Chapter Eleven Liquidity and Reserve Management Strategies and

Chapter Eleven Liquidity and Reserve Management: Strategies and Policies Mc. Graw-Hill/Irwin © 2008 The Mc. Graw-Hill Companies, All Rights Reserved

Liquidity The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -2 © 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 11 -3 © 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 11 -4 © 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 11 -5 © 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 11 -6 © 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 Subject to Immediate Repayment • Sensitivity to Changes in Interest Rates • Central Role in the Payment Process Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -7 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Strategies for Liquidity Managers • 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 11 -8 © 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 and Selling Them When Liquidity is Needed Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -9 © 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 11 -10 © 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 11 -11 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -12 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Borrowed Liquidity 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 11 -13 © 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 11 -14 © 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 11 -15 © 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 11 -16 © 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 11 -17 © 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 11 -18 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -19 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Customer Relationship Doctrine Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -20 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Liquidity Indicator Approach • Cash Position Indicator • Liquid Security Indicator • Net Federal Funds Position • Capacity Ratio • Pledged Securities Ratio Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e • Hot Money Ratio • Deposit Brokerage Index • Core Deposit Ratio • Deposit Composition Ratio • Loan Commitment Ratio 11 -21 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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 11 -22 © 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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -23 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

U. S. Legal Reserve Requirements • First $7. 8 Million have 0 Legal Reserves • 3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $48. 3 Million • 10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $48. 3 Million • Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments • The $48. 3 Million Amount is Adjusted Annually Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -24 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -25 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Reserve Computation Period The Period of Time Over Which a Bank Calculates its Legal Reserve Requirement Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -26 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Reserve Maintenance Period The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e 11 -27 © 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 11 -28 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.