Liability & Liquidity Management

1. Liability & Liquidity Management Class 23, Chap 18

2. Lecture Outline Purpose: to understand how reserve requirements relate to liquidity management, how monetary policy can be implemented through bank reserves, and how to calculate and maintain reserve requirements. • Economic Benefits of Reserve Requirements • Calculating Reserve Requirements • Managing Reserves • Liability Management (if there is time)

3. Liquid Asset – Review • What makes an asset liquid? • Can be turned in to cash quickly • At low cost – or – with little to no loss in principal value • Traded in a liquid market – large transactions do not move the price much • What are the costs and benefits of holding liquid assets? • Benefit – liquidity concerns are alleviated (protect against bank runs) • Cost – Liquid assets have low yield – there is an earnings penalty – Lower yield can cause FIs not to meet payments on liability claims – In the extreme this leads to insolvency – which can be contagious • What are the costs and benefits of holding illiquid assets • Benefit – they have higher yield • Cost – increase liquidity risk

4. Economic Benefits of Reserve Requirements

5. Regulation of Liquid Assets • Question: what do reserve requirements have to do with managing liquidity at banks? • Regulators force banks to hold a minimum level of liquid assets (reserve requirements) for 3 reasons • Meet expected & unexpected liability withdrawals managing net depository drain • Monetary policy • Economic stability tax

6. 2. Reserve Requirements & Monetary Policy • If the Fed was concerned about inflation how would they change the money supply? • Reduce the money supply “tight monetary policy” • Could they do this using bank reserves? • DIs are required to hold cash in reserve at the Fed – so if the Fed wanted to extract money from the economy they could increase reserve requirements • Could the Fed increase the money supply using bank reserves? • If the Fed decreases reserve requirements by $1 will the money supply increase by $1?

7. 2. RR & MP The Multiplier Effect Bank lends out $100 to a manufacture Manufacture uses $90 to purchase new equipment Fed lowers reserve requirement – frees up $100 Supplier pays for raw materials and deposits $40 profit at the bank • Multiplier Effect • Of the $100 reduction in reserve requirements the bank issued $136 in new loans • Decrease reserve requirements can result in money creation Bank pays $4 reserve requirement and lends out the remaining $36

8. 3. Reserve Requirements & Taxes • By requiring banks to hold reserves the government forces them to invest in government securities • The securities (deposits) earn less interest than other lending opportunities • The benefit of this lost interest is realized by the government in the form of a more stable economy Forgone interest income on high yield investments (loans) Interest paid on reserves at the Fed Tax = –

9. Risk Return Tradeoff of Liquid Assets • Each FI will have a mix of liquid & illiquid assets that will work best for the firm • Ideally the FI would be able to choose that mix to maximize value • Do all banks get to freely choose and set this mix? • NO! An FI may be forced to hold more liquid assets than is optimal – required reserves • In this case the FI may try to find a loophole to hold less reserves – can they? • Liquid Assets • Low yield (returns) • Easily converted to cash • Illiquid Assets • high yield (returns) • Converted to cash at a deep discount

10. Calculating Reserve Requirements

11. Calculating Reserves – The Basics • Depository Institutions employ a reserve manager who determines whether the DI is holding too much/little cash reserves • How do we determine the amount of reserves to be held? • Cash reserves are held against “Net Transaction Accounts” Amount due from other DIs – = Transaction Accounts Cash in the process of being delivered Net Transaction Accounts –

12. Calculating Reserves – The Basics • Transaction Accounts: includes all accounts or deposits on which the account holder may: • Make withdrawals by negotiable or transferable instruments • Make more than 3 monthly telephone or preauthorized fund transfers for the purpose of making payment to a third party • Demand deposit accounts, NOW accounts, share profit accounts (credit union) • Reserve Requirements (Federal Reserve):

13. Suppose a DI manager determines that the DI must maintain an average reserve for the next two weeks against 72 million in net transaction accounts. How much cash must the DI hold on reserve (on average) over the next two weeks?

14. Calculating Reserves – In Practice • In practice, the reserve manager needs two pieces of information to determine the reserve requirement at any given time • The period over which the reserve requirement is computed • The period over which the reserve requirement is maintained • In the US historical data is used to compute the reserve requirement to be maintained over the maintenance period

15. Calculating Reserves – Computation Period • Computation period: • The period over which data is collected and the reserve requirement is computed • The computation period begins on a Tuesday and ends 14 days later on that Monday (both the first Tuesday and last Monday are included in the period) • The average net transaction account balance is calculated over this period • Reserve requirements are calculated against the average net transaction account balance Tuesday Monday 28 29 30 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 June July Computation Period

16. Calculating Reserves – Maintenance Period • Maintenance period: • Period over which the reserve requirement must be maintained • There is a 30 day gap between the beginning of the reserve computation period and the beginning of the reserve maintenance period • Over the 14 day maintenance period, the DI must maintain average reserves equal to the requirement calculated over the computation period (two weeks ago) No specific day No specific day 28 29 30 31 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 July August Maintenance Period

17. Calculating Reserves – Timing 30 day lag The maintenance period begins 30 days after the first day the computation period 28 30 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 1 3 5 7 9 11 13 June July August Computation Period Maintenance Period • Find the average net transaction account balance over this period • Calculate the reserve requirements against this average balance • The DI must maintain an average reserve equal to that computed over the computation period over this period

18. How are Reserves Held? • Cash reserves can be held in two different ways: In the vault at the bank – vault cash On Deposit at the Federal Reserve

19. Calculating Reserves – Example Amount due from other DIs – – = = 240 Cash in the process of being delivered Transaction Accounts Net Transaction Accounts Net Transaction Accounts – Step #1 Calculate the net transaction account balance each day – $1,850 140 = 1,470

20. Calculating Reserves – Example Average 1,350.714 Step #2: Calculate the average net transaction account balance over the period

21. Calculating Reserve – Example Average 1,350.714 The bank must keep an average of $131.635 Million in reserves over the 14 day maintenance period July 30 – August 12 Step #3: Calculate the Reserve Requirement

22. Calculating Reserves – Example 25.357 Average 1,350.714 Step #4: Calculate the Required Reserve to be held at the Fed • The DI can hold reserves in the vault or at the Fed • The DI can deduct the average vault cash over the computation period to determine the average reserves required to be held at the Fed over the maintenance period Reserves at the Fed 131.653-25.357=$106.296M

23. Calculating Reserves – Example • What does that mean? • Over the14 day maintenance period beginning on July 30 and ending on August 12, the DI must maintain average cash reserves at the Fed of $106.296M • Does the DI need to have $106.296M in deposits at the Fed every day? Example: Suppose the DI holds an average of 95.5 Mill at the Fed for the first 12 days of the maintenance period how much would it have to hold over the next two days to meet its Reserve Requirement? Step #2 Find addition reserve needed Step #1 Back out the current sum Give it a try The DI must hold a total of $342.144 Million over the next two days. An average of $171.072 Mill per day

24. Calculating Reserves – Example Example: Suppose the DI holds an average of 95.5 Mill at the Fed for the first 12 days of the maintenance period how much would it have to hold over the next two days to meet its Reserve Requirement? (RR = 106.296) Step #2 Find addition reserve needed Step #1 Back out the current sum The DI must hold a total of $342.144 Million over the next two days. An average of $171.072 Mill per day

25. Managing Reserves

26. Managing Reserve – Loophole 25.357 Average 1,350.714 • The balance on Friday is carried over to Saturday and Sunday. • Friday’s balance is more heavily weighted in the average • If an FI wanted to lower its reserve requirement, they could lower the balance of their net transaction deposits on Friday What do you notice about these values?

27. Managing Reserves – Loophole • Why would DIs want to lower their reserves? • The optimal level of reserves may be below the required reserves • How can they lower the net transaction account balance • In the past DIs have moved deposits across boarders. On Friday, they transfer deposits to a foreign subsidiary and bring them back on Monday. • Offer customer a “sweep account”: On Friday, the customers balance is swept out of the demand deposit account and into a higher interest bearing account. On Monday the transaction is automatically reversed.

28. Managing Reserves – Undershooting • The Fed will allow a DI to under shoot the reserve requirement by 4% with no penalty but the shortfall must be made up in the next maintenance period Example: what range of average reserves can a DI hold over the maintenance period without incurring penalties if their required reserve is $584.23M How much reserves would the DI be required to hold over the next maintenance period if the required reserve over this maintenance period is $492.34M and the DI maintained an average reserve of $561M over the last maintenance period. Penalties: Explicit: the bank is charged interest on any deficit over 4%. The rate is equal to the Central Bank discount rate + 2% Implicit: The Fed will usually monitor the bank more closely especially after several offences

29. Managing Reserve – Overshooting • The DI can carry forward up to 4% of any surplus reserves to satisfy reserve requirements over the next maintenance period Example: find the amount that can be carried forward to the next maintenance period if the current reserve requirement is 168.35 and the DI maintained average reserves of 179.54. • Excess reserves (above the reserve + 4%) are costly to the DI because they do not earn interest at the Fed and cannot be carried forward. Opportunity Cost

30. DI Deposits at the Federal Reserve 1.6 Trillion • What happened at the end of 2008? • In 2008 the Fed began paying interest on deposits for the first time; it set the interest rate equal to their target for the market rate – what would this do? Source: St Luis Fed It essentially eliminated the opportunity cost of holding cash reserves

31. Why Are Banks Holding Reserves Government introduced several liquidity facilities give banks access to financing Reserves begin to increase Fed begins selling Treasures and other assets to reduce bank reserves. Fed sells Treasuries to banks and banks use excess reserves to buy them. • The size of the balance sheet remains relative constant • Liquidity facilities increase • Repo agreements (form of lending) • Securities lent increase – these securities (T-notes) may have been lent to dealers to cover collateral requirements or delivery on repos • The Fed is selling off large quantities of assets to support increased lending activity around the Bear event. Source: Why are Banks Holding So Many Excess Reserves?, Todd Keister and James McAndrews

32. Why Are Banks Holding Reserves Fed begins direct purchase of agency mortgage-backed securities So at this point things are still relatively balanced. Banks can use reserves to payback the loans (liq. Fac.). The fed can use payments on liquidity facilities to payback treasury. • Lehman Brothers • The Fed expands liquidity facilities injecting more cash into banks and increasing reserves. • The Fed can no longer keep reserves low by selling assets • The Fed can not allow the new money to flow into the economy – this would lower interest rate and create inflation • To keep banks from lending it starts paying interest on excess reserves. • Treasury SPF program • Treasury issue new securities (purchased by banks). Proceeds are left on deposit at the fed • This also decreases bank reserves but the size of the program was limited The Fed begins to pay interest on reserves to keep them at the fed (next best thing to reducing reserves) Source: Why are Banks Holding So Many Excess Reserves?, Todd Keister and James McAndrews

33. Example: A bank has an average net transaction account balance from August 10-23 of $914.36 mill and a average cash account balance of $32.214 mill over the same period. The bank is carrying forward a reserve deficit of 2.276 mill from the last maintenance period. calculate the reserve requirement – over what date range must this be maintained how much needs to held in reserves at the fed and how much can be held in vault cash calculate the minimum reserve requirement that can be maintained without penalty calculate the maximum reserve that may be carried forward to the next period

34. Liability Management

35. Liability Portfolio Structure • Ideally, DIs would like to construct a liability portfolio with low borrowing cost and low withdrawal risk • This is very hard to do because low cost liabilities are subject to high withdrawal risk (deposits) • DIs must structure their liability portfolios to balance • High borrowing cost low withdrawal risk liabilities • Low borrowing cost high withdrawal risk liabilities • Next we will review several different liability instruments DIs can use and the costs/withdrawal risk of each

36. Liability Structure Demand Deposits • Withdrawal risk – High: • Expected, such as weekend money. Unexpected, such as bank runs • Cost – Low • Explicit interest rate = 0%, Implicit interest rate Interest Bearing Checking (NOW) Accounts • Definition : • Checkable deposits with a minimum account balance – interest is paid when the balance is above the minimum • Withdrawal risk – High • Interest payment (both implicit and explicit) reduces withdrawal risk • Cost – Low • Explicit – paid if the balance is above the minimum and Implicit interest rate

37. NOW account example – suppose a depositor holds on average $250 for three months, $500 for three months and $1000 for the remaining 6 months of the year in a NOW account. The account pays 5% pa. The depositor writes an average of 50 checks per month and pays $0.10 per check. (i) Calculate the total interest earned by the depositor if the minimum balance is $500 (ii) Calculate the total interest earned if the minimum balance is $250 and the depositor pays $.05 per check

38. Lecture Summary • Economic Benefits of Reserve Requirements • Calculating Reserve Requirements • Managing Reserves • Liability Management (if there is time)

39. Liability Structure Passbook Savings • Definition: • Non-checkable savings account, no minimum, no minimum term, no specified frequency of deposits, and no notice or penalty for withdrawals. DI can delay payment • Withdrawal Risk – Mid • Less liquid than demand deposits. Depositor usually needs to be physically present to withdraw funds • Cost – Low • Explicit rate usually higher than NOW accounts, implicit rate (likely to be small) Money Market Deposit Accounts • Definition: • Checking account that pays interest based on the current rate in the money market • Withdrawal Risk – Mid • No limit on the number of checks that can be written, but they pay a higher rate than NOW accounts which reduces withdrawal risk.

40. Liability Structure Money Market Deposit Accounts (Cont’d) • Cost – • The explicit interest rate is the main cost of MMDA Retail Time Deposits & Certificates of Deposit (CDs) • Definition: • Savings account with a defined term, penalties are incurred for early withdrawal. Retail CD face value under $100,000. Size maturity and rate are negotiable but most DIs have standard terms on retail CDs • Withdrawal Risk – Low • Funds are locked up for a pre-specified term. DIs can control deposits by changing the maturity and rate on CDs in general maturities vary from 2 weeks to 8 years • Cost – Mid to High • The explicit interest rate is the main cost. Investors are subject to state and local taxes which the DI usually needs to compensate for

41. Liability Structure Whole Sale or Negotiable CDs • Definition: • CD with minimum deposit size of $100,000 that can be resold • Withdrawal Risk – Low • Negotiable means that the CD can be resold in the secondary market by tittle reassignment. This reduces likelihood of early withdrawal and reduces withdrawal risk. However, investors may not rollover the CD, which will constrain DI funding • Cost – High • Explicit interest is the main cost and is comparable to the rate on commercial paper. Investors are usually highly sophisticated so rates must be competitive. Deposits not insured so rates need to be higher to compensate investors. Federal Funds • Definition: • Short-term (usually overnight) uncollateralized interbank loans of excess reserves • Withdrawal Risk – Low • This is a loan, once funds have been committed there is very little chance that the loan will be call early. However, there is always the risk that the loan will not be renewed – rollover risk

42. Liability Structure Federal Funds (Cont’d) • Cost – High • The federal funds rate – set by DIs who trade in the federal funds market Repurchase Agreements • Definition: • These are basically collateralized loans – collateral reduces credit risk from the borrower – usually short-term (overnight) maturities • Withdrawal Risk – Low • Once the contract has been negotiated there is very little chance that the funds will be recalled early. However, the repo may not be renewed – rollover risk (Bear Stearns) • Cost – High • The explicit interest rate is the main cost. Because the repo is collateralized, the cost usually falls below the federal funds rate

43. Liability Structure Other Borrowing Options • Bankers Acceptance – this is the promise note to make a payment in the future that has been accepted and guaranteed by the DI • Example: XYZ auto dealer does not currently have the money to purchase more inventory and has not established a credit line with the new manufacture. XYZ can go to its bank and fill out the paper work “draft” to have its bank pay for the cars after they have been delivered. Once the draft is “accepted” it becomes a bankers acceptance – a guaranteed payment by the bank in the future • Commercial Paper – Unsecured short-term promissory note issued by corporations to raise short-term funding • Generally have maturities less than 270 days • Limited secondary market so CP is usually held to maturity • Subsidiaries cannot usually issue CP but they can get funding through an issue by the parent which is funneled to the sub. This is called “down stream” financing

44. Liability Structure Other Borrowing Options (cont’d) • Medium Term Notes – 5-7 year bonds this is a safe source of financing; it is not subject to reserve requirements, deposit insurance premiums or withdrawal • Discount Window – short-term loans from the Federal Reserve taken at the discount rate, which is usually a little higher than the federal funds rate