Bank Liquidity Management Chapter Eleven Liquidity The Availability
Bank Liquidity Management Chapter Eleven
Liquidity • The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost • The size and volatility of cash requirements affect the liquidity position of the bank ▫ Examples of transaction that affect the bank’s cash balance and liquidity position: Deposits and withdrawals; loan disbursements and loan payments Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Demands for Liquidity • Customer Deposit Withdrawals • Credit Requests from Quality Loan Customers • Repayment of Nondeposit Borrowings • Operating Expenses and Taxes • Payment of Stockholder Dividends Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
A Financial Firm’s Net Liquidity Position L = Supplies of Liquid Funds - Demands for Liquidity Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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 Liquidity and Profitability. The More Resources Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Financial Firm’s Expected Profitability. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Why Banks and Their Competitors Face Significant Liquidity Problems • Imbalances Between Maturity Dates of Their Assets and Liabilities • High Proportion of Liabilities (especially demand deposits and money market borrowings) Subject to Immediate Repayment • Sensitivity to Changes in Interest Rates ▫ May affect customer demand for deposits ▫ May affect customer demand for loans • Central Role in the Payment Process, Reputation and Public Confidence in the System Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Strategies for Liquidity Managers 1. Think about what is a liquid asset? 2. Identify strategies for liquidity management. • Asset Liquidity Management or Asset Conversion Strategy • Borrowed Liquidity or Liability Management Strategy • Balanced Liquidity Strategy Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Asset Liquidity Management This Strategy Calls for Storing Liquidity in the Form of Liquid Assets (T-bills, fed funds loans, CDs, etc. ) and Selling Them When Liquidity is Needed Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Options for Storing Liquidity • Treasury Bills • Fed Funds Sold to Other Banks • Purchasing Securities for Resale (Repos) • Deposits with Correspondent Banks Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e • Municipal Bonds and Notes • Federal Agency Securities • Negotiable Certificates of Deposits • Eurocurrency Loans © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Asset Liquidity Management is Not Costless and Include Opportunity Cost: • Loss of Future Earnings on Assets That Must Be Sold • Transaction Costs (Commissions) 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Borrowed Liquidity (Liability) Management This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Sources of Borrowed Funds Federal Funds Purchased Selling Securities for Repurchase (Repos) Issuing Large CDs (Greater than $100, 000) Issuing Eurocurrency Deposits Securing Advance from the Federal Home Loan Bank • Borrowing Reserves from the Discount Window of the Federal Reserve • • • Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Borrowed Liquidity (Liability) Management Strategy Advantages • Borrow Only When There is a Need for Funds • Volume and Composition of the Investment Portfolio Can Remain Unchanged • The Institution Can Control Interest Rates in Order to Borrow Funds (raise offer rates when needs requisite amounts Mc. Graw-Hill/Irwin funds) Bankof Management and Financial Services, 7/e Disadvantages • Highest Expected Return But Carries the Highest Risk Due to Volatility of Interest Rates and Possible Rapid Changes in Credit Availability • Borrowing Cost is Always Uncertain-> Uncertain Earnings • Borrowing Needs Can Be Interpreted as a Signal of Financial Difficulties © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Balanced Liquidity Management Strategy The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Methods for Estimating Liquidity Needs • Sources and Uses of Funds Approach • Structure of Funds Approach • Liquidity Indicator Approach • Signals from the Marketplace Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Structure of Funds Approach • A Bank’s Deposits and Other Sources of Funds Divided Into Categories. For Example: ▫ ‘Hot Money’ Liabilities (volatile liabilities) ▫ Vulnerable Funds ▫ Stable Funds (core deposits or core liabilities) • Liquidity Manager Set Aside Liquid Funds According to Some Operating Rule Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Liquidity Indicator Approach (Based on Experience and Industry Averages) • Cash Position Indicator • Hot Money Ratio • Liquid Security Indicator • Deposit Brokerage Index • Net Federal Funds Position • Core Deposit Ratio • Capacity Ratio • Deposit Composition Ratio • Pledged Securities Ratio • Loan Commitment Ratio Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
The Ultimate Standard: 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Legal Reserves • Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities • Only 2 Kinds of Assets Can Be Used for This Purpose: 1) Cash in the Vault; 2) Deposits Held in a Reserve Account With the Regional Fed. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
U. S. Legal Reserve Requirements • In 2007 -2008, first $9. 3 Million have 0 Legal Reserves • 3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $43. 9 Million ($43. 9 million is known as the reserve tranche and changes every year) • 10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $43. 9 Million • Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments • The $43. 9 Million Amount is Adjusted Annually • The Money Position Manager Oversees the Institution’s Legal Reserve Account Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Calculating Required Reserves Any deficit above 4% may be assessed an interest penalty equal to the Federal Reserve’s discount (primary credit) rate at the beginning of the month plus 2 percentage points applied to the amount of the deficiency. Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its efficiency. Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Factors Influencing the Money Position Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Sweep Account • Volume of Legal Reserves Held at the Fed Has Declined in Recent Years Largely Due to Sweep Accounts • 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 ▫ Retail Sweep ▫ Business Sweep Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Other Factors to Influence Legal Reserves • Use of Fed Funds Market ▫ The cheapest source ▫ But very volatile ▫ Managers rely on the Fed funds target rate (the most volatile on the settlement date) • Other Options ▫ Sell liquid securities ▫ Draw upon excess correspondent balances ▫ Enter into repurchase agreements for temporary borrowings ▫ Sell new time deposits ▫ And borrow in the Eurocurrency market Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Factors in 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 • Outlook for Central Bank Monetary Policy • Regulations Applicable for Liquidity Sources Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Functions of a Bank’s Security Portfolio • • • Stabilize the Bank’s Income Offset Credit Risk Exposure Provide Geographic Diversification Provide Backup Source of Liquidity Reduce Tax Exposure Serve as Collateral Hedge Against Interest Rate Risk Provide Flexibility Dress Up a Bank’s Balance Sheet Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Federal Regulators Require Written Investment Policy • The Quality or Degree of Default Risk Exposure the Institution is Willing to Accept • The Desired Maturity Range and Degree of Marketability Sought for All Securities • The Goals Sought for its Investment Portfolio • The Degree of Portfolio Diversification the Institution Wishes to Achieve with its Investment Portfolio Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Investment Instruments Available to Financial Firms • Money Market Instruments ▫ Reach Maturity Within One Year ▫ Low Risk ▫ Ready Marketability • Capital Market Instruments ▫ Maturity Beyond One Year ▫ Higher Expected Rate of Return ▫ Capital Gains Potential Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Money Market Instruments Used by a Bank • • Treasury Bills Short-Term Treasury Notes and Bonds Federal Agency Securities Certificates of Deposit Eurocurrency Deposits Banker’s Acceptances Commercial Paper Short-Term Municipal Obligations Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Capital Market Instruments Used by a Bank • Treasury Notes and Bonds Over One Year to Maturity • Municipal Notes and Bonds • Corporate Notes and Bonds • Asset Backed Securities Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Other More Recent Investment Instruments • Structured Notes ▫ Basic Characteristics ▫ Benefits ▫ Recent Problems During Financial Crisis • Securitized Assets ▫ Pass-through securities ▫ CMOs ▫ Mortgage-backed bonds (guarantees from government agencies; higher average yields; lack of good-quality assets; superior liquidity) • Stripped Securities ▫ PO and IO securities Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Dominant Investments Held By Banks in 2007 • Obligations of the U. S. Government and Government Agencies ▫ About 60% of Banks’ Investments Overall ▫ Smaller Banks Hold a Higher Ratio Compared to Large Banks • State and Local Government Obligations • Nonmortgage-Related-Asset-Backed Securities • Hold Relatively Few Private-Sector Securities Overall, Investment Securities Account for Less 20% of Total Assets Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Factors Affecting the Choice of Securities • Expected Rate of Return • Tax Exposure • Interest Rate Risk • Credit Risk • Business Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e • Liquidity Risk • Call Risk • Prepayment Risk • Inflation Risk • Pledging Requirements © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Expected Rate of Return Yield to Maturity Holding Period Return Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Tax Exposure • The Tax Status of State and Local Government Bonds • Bank Qualified Bonds • Tax Swapping Tool • The Portfolio Shifting Tool Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Interest Rate Risk • Rising Interest Rates Lowers the Value of Previously Issued Bonds • Longest –Term Bonds Suffer the Greatest Losses • Many Interest Rate Risk Tools Including Futures, Options, and Swaps Exist Today Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Default Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Business Risk • Risk that the Economy of the Market Area they Serve May Turn Down • Security Portfolio Can Offset This Risk • Securities Can be Purchased From Outside Market Area Served Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Liquidity Risk • Breadth and Depth of Secondary Market ▫ Number of Traders on an Given Day ▫ Volume of Trades on Any Given Day • Treasury Securities are Generally the Most Liquid Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Call Risk • Corporations and Some Governments Reserve the Right to Retire the Securities in Advance of Their Maturity • Generally Called When Interest Rates a Have Fallen • Investor Must Find New Security – Often with a Lower Return Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Prepayment Risk • Specific to Asset-Backed Securities • Most Consumer Mortgages and Loans Can Be Paid Off Early • Caused by Loan Refinancing Which Accelerate When Interest Rates Fall • Caused by Asset Turnover When Borrowers Move or are Not Able to Meet Loan Payments and Asset is Sold Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Inflation Risk • Purchasing Power from a Security or Loan May be Eroded by Rising Prices • Recently Developed Inflation Risk Hedge – Treasury Inflation Protected Securities • Both Coupon Payments and Principal Adjusted Annually for Inflation Based on Consumer Price Index Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Pledging Requirements • Depository Institutions Cannot Accept Federal, State and Local Government Deposits Unless Acceptable Collateral is Pledged • Generally Treasury Securities, Government Agency Securities and Selected Municipal Securities Can Be Used as Collateral Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Investment Maturity Strategies • • • The The The Ladder or Spaced-Maturity Policy Front-End Load Maturity Policy Back-End Load Maturity Policy Barbell Strategy Rate Expectation Approach Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
Maturity Management Tools • The Yield Curve ▫ Picture of How Market Interest Rates Differ Across Differing Maturities ▫ Constructed Most Easily with Treasury Securities ▫ Provides Information About Under and Over Priced Securities ▫ Provides Information About the Risk Return Trade. Off • Duration ▫ Present Value Weighted Average Maturity of the Cash Flows ▫ Can Be Used to Insulate the Securities From Interest Rate Changes Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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