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CHAPTER TEN Liquidity And Reserve Management: Strategies And Policies

CHAPTER TEN Liquidity And Reserve Management: Strategies And Policies.

carolena-feehan
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CHAPTER TEN Liquidity And Reserve Management: Strategies And Policies

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  1. 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.

  2. Liquidity The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost

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

  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 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.

  7. Why Banks and Their Competitors Face Significant Liquidity Problems • Imbalances Between Maturity Dates of Their Assets and Liabilities • High Proportion of Liabilities Subject to Immediate Repayment • Sensitivity to Changes in Interest Rates • Central Role in the Payment Process

  8. Strategies for Liquidity Managers • Asset Liquidity Management or Asset Conversion Strategy • Borrowed Liquidity or Liability Management Strategy • Balanced Liquidity Strategy

  9. Asset Liquidity Management This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed

  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. Treasury Bills Fed Funds Sold to Other Banks Purchasing Securities for Resale (Repos) Deposits with Correspondent Banks Municipal Bonds and Notes Federal Agency Securities Bankers’ Acceptances Commercial Paper Eurocurrency Loans Options for Storing Liquidity

  12. Costs of Asset Liquidity Management • Loss of Future Earnings on Assets That Must Be Sold • Transaction Costs 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. Borrowed Liquidity Management This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs

  14. 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

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

  16. 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

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

  18. 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

  19. 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

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

  21. Liquidity Indicator Approach • Cash Position Indicator • Liquid Security Indicator • Net Federal Funds Position • Capacity Ratio • Pledging Securities Ratio • Hot Money Ratio • Short-Term Investments to Sensitive Liabilities Ratio • Deposit Brokerage Index • Core Deposit Ratio • Deposit Composition Ratio

  22. 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

  23. Legal Reserves Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities

  24. 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 Million • 10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $42.1 Million • Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments • The $42.1 Million Amount is Adjusted Annually

  25. 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

  26. Reserve Computation Period The Period of Time Over Which a bank Calculates its Legal Reserve Requirement

  27. Reserve Maintenance Period The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands

  28. 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

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