Chapter Eleven Liquidity and Reserves Management Strategies and

Chapter Eleven Liquidity and Reserves Management: Strategies and Policies Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

11 -2 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.

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

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

11 -5 Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

11 -6 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.

11 -7 Quick Quiz: Comprehensive Problem 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 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 Mc. Graw-Hill/Irwin © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved. Bank Management and Financial Services, 7/e week?

11 -8 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.

11 -9 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.

11 -10 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.

11 -11 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.

11 -12 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.

11 -13 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.

11 -14 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.

11 -15 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.

11 -16 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.

11 -17 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.

11 -18 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.

11 -19 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.

11 -20 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.

11 -21 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.

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

11 -23 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.

11 -24 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 © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

11 -25 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.

11 -26 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.

11 -27 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.

11 -28 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.

11 -29 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.

11 -30 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.

11 -31 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.

11 -32 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.

11 -33 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.

11 -34 Quick Quiz • What are the principal differences among asset liquidity management, liability management, and balanced liquidity management? • What guidelines should management keep in mind when it manages a financial firm’s liquidity position? • What is money position management? • What is the principal goal of money position management? • What factors should a money position manager consider in meeting a deficit in a depository 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.