Chap11 liquidity and reserve management strategies and policy PDF

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies CHAPTER 11 LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES Goal of This Chapter: The purpose of this chapter is to explore the reasons why financial institutions often face heavy demands for immediately spendable fund...

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

CHAPTER 11 LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES

Goal of This Chapter: The purpose of this chapter is to explore the reasons 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. Key Topics in This Chapter      

Sources of Demand for and Supply of Liquidity Why Financial Firms Have Liquidity Problems Liquidity Management Strategies Estimating Liquidity Needs The Impact of Market Discipline Legal Reserves and Money Management Chapter Outline

I. Introduction: Meaning of Liquidity II. The Demand for and Supply of Liquidity A. Sources of Liquidity Demands B. Sources of Liquidity Supplies C. Net Liquidity Position and Liquidity Surpluses and Deficits III. Why Financial Firms Often Face Significant Liquidity Problems A. Maturity Mismatches B. Sensitivity to Changes in Market Interest Rates C. Meeting Demand for Liquidity and Public Confidence IV. Strategies for Liquidity Managers A. Asset Liquidity Management (or Asset Conversion) Strategies B. Borrowed Liquidity (Liability) Management Strategies C. Balanced Liquidity Management Strategies D. Guidelines for Liquidity Managers V. Estimating Liquidity Needs A. The Sources and Uses of Funds Approach B. The Structure of Funds Approach C. Liquidity Indicator Approach D. The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace 1. Public confidence 2. Stock price behavior 3. Risk premiums on CDs and other borrowings 4. Loss sales of assets 5. Meeting commitments to credit customers 6. Borrowings from the central bank

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

VI. Legal Reserves and Money Position Management A. The Money Position Manager B. Legal Reserves C. Regulations on Calculating Legal Reserve Requirements 1. Reserve Computation 2. Reserve Maintenance 3. Reserve Requirements 4. Calculating Required Reserves 5. Penalty for a Reserve Deficit 6. Clearing Balances D. Factors Influencing the Money Position 1. Controllable Factors 2. Noncontrollable Factors 3. An Example 4. Use of the Federal Funds Market 5. Other Options besides Fed Funds 6. Bank Size and Borrowing and Lending Reserves for the Money Position 7. Overdraft Penalties VII. Factors in Choosing among the Different Sources of Reserves A. Immediacy of need B. Duration of need C. Access to the market for liquid funds D. Relative costs and risks of alternative sources of funds E. The interest rate outlook F. Outlook for central bank monetary policy G. Rules and regulations applicable to a liquidity source VIII. Central Bank Reserve Requirements around the Globe IX. Summary of the Chapter Concept Checks 11-1. What are the principal sources of liquidity demand for a financial firm? The most pressing demands for liquidity arise principally from customers withdrawing money from their deposits and from credit requests. However, demands for liquidity can also come from paying off previous borrowings, operating expenses and taxes incurred during operations and from payment of a cash dividend to stockholders. 11-2. What are the principal sources from which the supply of liquidity comes? Supplies of funds stem principally from incoming deposits, sales of assets, particularly marketable securities and repayments of outstanding loans. Liquidity also comes from the sale of nondeposit services and borrowings from the money market.

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

11-3. Suppose that a bank faces the following cash inflows and outflows during the coming week: (a) deposit withdrawals are expected to total $33 million, (b) customer loan repayments are expected to amount to $108 million, (c) operating expenses demanding cash payment will probably approach $51 million, (d) acceptable new loan requests should reach $294 million, (e) sales of bank assets Concept Check are projected to be $18 million, (f) new deposits should total $670 million, (g) borrowings from the money market are expected to be about $43 million, (h) nondeposit service fees should amount to $27 million, (i) previous bank borrowings totaling $23 million are scheduled to be repaid, and (j) a dividend payment to bank stockholders of $140 million is scheduled. What is this bank s projected net liquidity position for the coming week?

Cash Inflows Customer Loan Repayments Sales of Bank Assets New Deposits Money-Market Borrowings Nondeposit Service Fees

$108 18 670 43 27

(In millions of dollars) Cash Outflows Deposit Withdrawals $33 Operating Expenses 51 New Loan Requests 294 Repayment of Previous Borrowings 23 Dividend to Stockholders 140

Total Cash Inflows

$866

Total Cash Outflows

Net Liquidity Position Projected for the Coming Week

Total Cash = Inflows

$541

Total Cash - Outflows

= $866 million - $541 million = + $325 million 11-4. 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 also monitor 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. 11-5. Why do financial firms face significant liquidity management problems? Financial institutions are prone to liquidity management problems due to:

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

(1) A maturity mismatch situation in which most depository institutions hold an unusually high proportion of liabilities subject to immediate payment, especially demand (checkable) deposits and money market borrowings; (2) The sensitivity of changes to their assets and liabilities values towards market interest-rate movements; and (3) Their central role in the payments process. 11-6. What are the principal differences among asset liquidity management, liability management, and balanced liquidity management? Asset management is a strategy for meeting liquidity needs, used mainly by smaller banks, in which liquid funds are stored in readily marketable assets that can be quickly converted into cash as needed. Liability management involves borrowing enough immediately spendable funds to cover demands for liquidity made against a bank. Balanced liquidity management calls for using both asset management and liability management to cover a bank's liquidity needs. 11-7. What guidelines should management keep in mind when it manages a financial firms liquidity position? It is important for a liquidity manager to: (a) keep track of the activities of other departments within the bank; (b) know in advance the planned activities of the bank's largest credit and deposit customers; (c) set clear priorities and objectives in liquidity management; and (d) react quickly to liquidity deficits and liquidity surpluses. Liquidity managers must know what other departments within the institution are doing because their activities affect the liquidity position and liquidity management decisions. The liquidity manager can make better decisions to profitably invest surplus liquid funds or avoid costly, lastminute borrowings if he or she knows what the bank's principal depositors and creditors will do in advance. By setting clear priorities and objectives the liquidity manager has a better chance to make sound decisions plus an ability to act quickly to invest surpluses in order to gain maximum income or avoid costly deficits and prolonged borrowings. 11-8. How does the sources and uses of funds approach help a manager estimate a financial institution s need for liquidity? The sources and uses of funds approach estimates future deposit inflows and estimated outflows of funds associated with expected loan demand and calculates the net difference between these items in each planning period.

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the difference between sources and uses of funds. When sources of liquidity (e.g., increasing deposits or decreasing loans) exceed uses of liquidity (e.g., decreasing deposits or increasing loans) then the financial firm will have a positive liquidity gap (surplus). Its surplus liquid funds must be quickly invested in earning assets until they are needed to cover future cash needs. On the other hand, when uses exceed sources, a financial institution faces a negative liquidity gap (deficit). It now must raise funds from the cheapest and most timely sources available. 11-9. Suppose that a bank estimates its total deposits for the next six months in millions of dollars to be, respectively, $112, $132, $121, $147, $151 and $139, while its loans (also in millions of dollars) will total an estimated $87, $95, $102, $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? Estimated Total Deposits $112 132 121 147 151 139

Estimated Total Loans $87 95 102 113 101 124

Change in Deposits

Change in Loans

Estimated Liquidity Deficit or Surplus

$ --+20 -11 +26 +4 -12

$ --+8 +7 +11 -12 +23

$ --+12 -18 +15 +16 -35

Clearly, the bank has projected liquidity surpluses (which should be profitably invested) in three out of six months, but a deficit is estimated for the third and last month which will have to be covered through borrowings and possibly through the sale of liquid assets.

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

11-10. What steps are needed to carry out the structure of funds approach to liquidity management? In the first step, the institution's deposits and other funds sources are divided into categories based upon their estimated probability of being withdrawn and, therefore, lost to the financial firm. 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. 11-11. 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? Total Liquidity Requirement = 0.80 ($19 million - 0.03 x $19 million) + 0.25 ($54 million - 0.03 x $54 million) + 0.05 ($112 million - 0.03 x $112 million) + ($132 million +O.08 x $132 million - $117 million) = $58.831 million 11-12. What is 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. 11-13. First National Bank posts the following balance sheet entries on todays date: Net loans and leases, $3,502 million; cash and deposits held at other banks, $633 million; Federal funds sold $48 million; U.S. government securities, $185 million; Federal funds purchased, $62 million; demand deposits, $988 million; time deposits, $2,627 million; and total assets, $4,446 million. How many liquidity indicators can be calculated from these figures?

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

(In millions of dollars) Liabilities

Assets Cash Deposits held at other Banks U.S. Government securities Net Loans and Losses Federal Funds Sold Total Assets

$ 633 $ 185 $3,502 $ 48 $4,446

Federal Fund Purchased

$

Demand Deposits Time Deposits

$ 988 $2,627

The liquidity indicators that we can construct from the foregoing figures include: Cash Position Indicator: Cash and Deposits Due from Other Banks Total Assets

=

$633 $4446

= 14.24 percent

Net Federal Funds Position: (Federal Funds Sold  Federal Funds Purchased) = Total Assets

($48 - $62) $4446

= - 0.31 percent

Capacity Ratio: Net Loans and Leases Total Assets

= $3,502 = 77.77 percent $4446

Deposit Composition Ratio: Demand Deposits Time Deposits

=

$988 = 37.61 percent $2,627

Liquid Securities Indicator: U.S. Government Securities Total Assets

=

$185 $4446

= 4.16 percent

11-14. How can the discipline of the marketplace be used as a guide for making liquidity management decisions?

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

No financial institution can tell for sure if it has sufficient liquidity until it has passed the market's test. Specifically, management should look at these signals: public confidence, stock price behavior, risk premiums on CDs and other borrowings, loss sales of assets, meeting commitments to credit customers and borrowings from the Federal Reserve banks. If problems exist in any of these areas, management needs to take a close look at its liquidity management practices to determine whether changes are in order. 11-15. What is money position management? Money position management is the management of a financial institution s liquidity position that requires quick decisions which may have long-run consequences on profitability. Most large depository institutions have designated an officer of the firm as money position manager. A money position manager is responsible for ensuring that the institution maintains an adequate level of legal reserves. Legal reserve requirements apply to all qualified depository institutions, including commercial and savings banks, savings and loan associations, credit unions, and agencies and branches of foreign banks that offer transaction deposits or nonpersonal (business) time deposits or borrow through Eurocurrency liabilities. 11-16. What is the principal goal of money position management? The money-position management s goal is to ensure that the bank has sufficient legal reserves to meet its reserve requirements as imposed by the central bank. Also make sure that it holds not more than the minimum legal requirement because excess legal reserves yield no income for the bank. 11-17. Exactly how is a depository institution s 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.

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

11-18. First National Bank finds that its net transactions deposits average $140 million over the latest reserve computation period. Using the reserve requirement ratios imposed by the Federal Reserve as given in the textbook, what is the bank's total required legal reserve? Total Required Legal Reserves

= 0.03 * [First $43.9-$9.3 million of Transaction Deposits] + .10*[Amount of Transaction Deposits in Excess of $43.9 million] = .03 * $34.6 + .10 * ($140 - $43.9) = $1.038 million + $9.61 million = $10.648 million

11-19. 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 averaged $1 million and the savings 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? The bank's total required legal reserves must be: Required Legal Reserves = 0.03 x [First $43.9  $9.3 million of Transactions Deposits] + 0.10 x [Transactions Deposits Over $43.9 million] = .03*$34.6 + .10*($200 - $43.9) = $1.038 million + $15.61 million = $16.648 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 $9,352,000. 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. 11-20. What factors should a money position manager consider in meeting a deficit in a depository institution s legal reserve account? Several factors must be taken into account by the money position 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. 11-21. What are clearing balances? Of what benefit can clearing balances be to a depository that uses the Federal Reserve System s check-clearing network?

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

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. 11-22. 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 11-23. What are sweeps accounts? Why have they led to a significant decline in the total legal reserves held at the Federal Reserve banks by depository institutions operating in the United States? A sweeps account is a service provided by banks where they sweep money out of accounts that carry reserve requirements (such as demand deposits and other checking accounts) into savings accounts which do not carry reserve requirements overnight. This service lower...