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Liquidity and Reserve Management: Strategies and Policies, CH. 11, Rose & Hudgins, 9th
ed., (F14)

EXAM - possible questions from Ch. 11 include three liquidity management strategies; liquidity
indicators definitions and relationship with liquidity and bank size; reserve requirements
computation and maintenance periods; and how to compute balance required to compensate for
correspondent services for a given fee amount and interest rate.

Liquidity is the ability to meet demands for funds, e.g., deposit withdrawals and loan demand.
See net liquidity position on p. 360. Banks must continually deal with liquidity surpluses, e.g.,
how and when to invest the surplus, or deficits, e.g., how and when to fund the deficit. There is a
TRADE-OFF between liquidity and profitability. Two risks are interest rate risk and availability
risk. As the percentage of demand deposit and other short-term market borrowings increases,
liquidity decreases. For example, if interest rates increase demand for loans may decrease;
however, the usage of credit lines with lower rates may be more utilized. An increase in rates may
decrease the value of assets that are being held for liquidity and the cost of borrowing increases.
If rates increase depositors are less likely to keep funds in demand (checking) deposits because
the opportunity cost of holding them increases.

KNOW Liquidity management strategies - pp. 363-366

A. Asset liquidity management (or asset conversion) - store liquidity in the form of liquid
assets; oldest strategy and used mainly by smaller banks; least risky strategy but has opportunity
cost associated with low rates on liquid assets and may involve transaction costs. A liquid asset
should be easy to sell quickly at or near its current market price with little risk of loss of
principal. This definition suggests a security with a very large market, very little credit risk, and a
short maturity.
B. Liability liquidity management (or borrowed or purchased liquidity) - only borrow
money when you need it but must have at least one source of funds that is reliable and very
interest rate-sensitive, e.g., large negotiable CDS, federal funds purchased, repurchase
agreements; most risky approach because cost and availability of funds can change rapidly,
particularly in a crisis situation.
C. Balanced (Asset and Liability) liquidity management - some of expected demands are
stored in assets and unexpected demands are met from short-term borrowing. Examples of asset
and liability options are on pp. 364-365; however, we will discuss them in more detail in Chapter
13 on nondeposit funds.

3. Estimating a Bank’s Net Funding Liquidity (L) Needs - pp. 366-378

A. Sources and uses of funds method -
L, as Dep and Loans; L, as Dep and Loans;
Need information on largest borrowers (unused lines of credit) and depositors
L, as Loan and Interest Payments to Bank  and Interest and Operating Payments by Bank ;
3 Key components for all deposits and loans – trend (e.g. 10-year trend), seasonal
(Christmas, timing of customers’ paychecks, tax time), and cyclical (business cycle deviation from
long-term trend)
Also include off-balance sheet activities, e.g., derivatives, loan commitments, SLCs
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B. Structure of funds – use a maturity ladder to estimate probability of each liability being
withdrawn and potential loan demand and set aside funds to meet withdrawals and loan demand
through liquid assets, including any discounts to sell quickly, or additional borrowing capacity;
may also use scenario analysis (best, worst & most likely scenarios)

C. Liquidity indicators, see pp. 366-367 – KNOW indicators (be able to define each
correctly and its relationship with liquidity)

The following ratios reflect stored liquidity in the assets and as the stored liquidity increases
(decreases) liquidity increases (decreases).
1. Cash position indicator: (cash and deposits due from depository institutions)/total assets. (+)
2. Liquid securities indicator: U.S. government securities/total assets. (+)
3. Net federal funds position: (fed funds sold – fed funds purchased)/total assets (+). Usually
decreases as bank size increases and is often negative for large banks.
4. Capacity ratio: net loans and leases/total assets (-); loans are among least liquid assets.
5. Pledged securities: pledged securities/total securities (-); as percent of pledged securities
increases the amount of securities that can be sold decreases. (6/30/14 = 37%)
6. Hot money ratio: ignore this ratio.

The following ratios reflect probability that the deposits will be withdrawn and as the probability
of withdrawal increases (decreases) liquidity decreases (increases).

7. Deposit brokerage index: brokered deposits/total deposits (-); deposits sold through brokers
are more likely to be interest rate sensitive and have a higher probability of withdrawal.
8. Core deposit ratio: core deposits (all deposits <$100,000)/total assets (+); smaller deposits are
less interest rate sensitive and less likely to be withdrawn. If one examines (core
deposits/domestic deposits) instead it usually is about 80% for all size banks.
9. Deposit composition ratio: demand deposits/time deposits (-); demand deposits are more likely
to be withdrawn than time deposits.

The following ratio reflects the probability that more loans will be demanded (particularly during
recessions) and as the probability of loan demand increases (decreases) liquidity decreases
(increases).

10. Loan commitments ratio: Unused loan commitments/total assets (-).

D. Signals from the Marketplace, p. 376-378: common examples of market discipline are
common stock price behavior and risk premiums on CDs or other borrowings.

4. Legal reserves and money position management - Comment: Historically, reserve requirements
were considered taxes by bankers when they were higher than what the bankers would hold
without the requirements because the funds, vault cash and deposits at Fed, did not earn any
interest. Banks may also hold clearing balances at Fed to cover any checks drawn against their
banks; however, banks earn credits on balances to cover services, e.g., FEDWIRE. Some central
banks in other countries do not charge reserve requirements, e.g., Bank of England. European
Central Bank (ECB) has binding requirements. Before 2008, the FED did not pay interest on
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required reserves. On December 16, 2008, the FED established interest rates on required and
excess reserve balances of 1/4 percent. SMITH (10/5/14): The rate on reserves may be the
new monetary policy tool when the FED decides to raise rates because the amount of
reserves is so large due to quantitative easing and the increase in the size of the FED’s
balance sheet.

A. The 2014 (2015) reserve requirements for net transaction accounts, i.e., checking and NOW
accounts, but not MMDAs and savings accounts, are 0% on $0-13.3M (14.5M), 3% on $13.3M
to 89.0M (103.6M) (changes over time as deposits grow (p. 380 explanation)), and 10% on
>$89.0M (103.6M)); requirements on non-personal time deposits and Eurocurrency liabilities are
0%; reserve requirements can be met with cash in the vault or deposits at the Fed. Know reserve
requirements on deposits and how to calculate required reserves; however, for test purposes
we will assume that the reserve requirement for ALL transaction deposits is 10%.
EXAMPLE: If transaction deposits = $200M, and savings and time deposits = $400M, what is
the reserve requirement balance? On an exam the answer to the question above would be
($200M X 0.1) + ($400M X 0.0) = $20M. If the bank’s vault cash averaged $15M during
maintenance period, the bank would need $5M in deposits at the regional Federal Reserve Bank.
B. Reserve computation period and reserve maintenance period - see p.379 diagram;
lagged reserve accounting (30-day lag):
Tu W Th F Sa Su M Tu W Th F Sa Su M Tu W
[reserve computation period -------------]
[reserve maintenance period ------------] +28 days

Effective on 7/30/98, the reserve maintenance period for weekly reporting institutions began 30
days after the beginning of the 2-week reserve computation period or 17 days after the end of the
period, e.g., if computation period is Jan.1-14, maintenance period is Jan. 31 - Feb. 13. The new
system added 28 days to the former two-day lagged contemporaneous reserve maintenance period
to make it easier to manage the reserve maintenance.

C. Sweep accounts (p. 383), a service that shifts customer deposits with reserve
requirements, usually on an overnight basis, into savings accounts. Sweep accounts cover over
$500B in deposit balances which lowers banks’ total required reserves and deposit costs, e.g.,
$500B in transaction accounts X 10% = $50B of reserve requirements. The payment of interest
on reserves should reduce the incentive to sweep accounts to avoid non-interest bearing reserve
requirements.

5. Cash & Balances Due from Depository Institutions, FDIC-insured banks, 6/30/14

Total Cash and Due $1,775 B (some large rounding errors below due to reporting)
(Includes $219B of noninterest-bearing balances*)

Cash items in process of collection (float) 142B (8.0%)

Currency and coin 57B
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Balances due from dep. inst. in US 78B (4.4%)

(Includes US branches of foreign banks, 6B)

Deposits at Fed 1,236B (69.6%)

(Note: was 4% of $400B = $16B on 3/31/07)

Balances due from banks in foreign countries 276B (15.5%)

Other not listed 43B (2.5%)
(Source: FDIC Statistics on Banking, http://www2.fdic.gov/SDI/SOB/)

*Noninterest bearing balances may represent payment for correspondent services that are
provided by other, usually larger, banks, e.g., core services are check clearing and providing coin
and currency but other services include data processing, investment and tax advice, loan
participations, and training. The bank receiving the services, the respondent, deposits the funds
with another bank and the amount is reflected as an asset, i.e., due from, and is a liability, due to,
for the bank providing the service. The opportunity cost on the noninterest funds pays for the
services. For example, on 6/30/14, noninterest bearing balances as a percent of total cash and due
were 30% and 12%, for banks less than $100M, and banks greater than $1B in total assets,
respectively. On 3/31/07 before the financial crisis when total cash and due was $400B and
deposits at FED were $16B, noninterest bearing balances as a percent of total cash and due were
75% and 56%, for banks less than $1B, and banks greater than $1B in total assets, respectively.
The noninterest-bearing balances may decrease due to consolidation and increases in interest rates
or increase due to decreases in interest rates. If services fee = $80,000 and the interest rate, i.e.,
opportunity cost, is 6%, the correspondent balance would be $1,333,333. $FEE = ($BALANCE
X RATE) or $BALANCE = ($FEE / RATE). If FEE is constant, as RATE increases (decreases),
then BALANCE decreases (increases). Know how to calculate correspondent balances to pay
for services fees. NOTE: As interest rates increase, earnings credits increase and deposit service
charges (fee income) may decrease.

Service Charges on DD = Fees = $80,000 – (Credit on Balance)

(.06 X $BAL)
(.06 X 1,333,333) = 0
(.06 X 1,000,000) = 20,000
(.07 X 1,000,000) = 10,000
(.05 X 1,000,000) = 30,000

The above example is also applicable to a nonfinancial business paying for services from a bank,
i.e., payment for services is a function of fees and a credit on balances held at bank.

Effective July 21, 2011 banks can pay interest on commercial checking accounts and this may
affect whether customers pay fees or receive interest.

KNOW: Foreign currency liquidity management is more complex than domestic liquidity
management. The simplest situation is where foreign currency liabilities (deposits and non-
deposit funding) are equal to foreign currency assets (loans, securities, and other assets) for each
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currency. As that equality becomes an unbalanced inequality, the liquidity risk increases. In other
words, foreign currency assets are funded by domestic funding or domestic assets are funded by
foreign currency funding. Large increases in exchange rates can affect the relative values of the
assets and liabilities and may also exacerbate a crisis where assets are not paid on time or liabilities
increase due to much higher demand by customers.

Iceland Banks Example:

Loans (ISK = Icelandic Krona) and Deposits (EUR = Euro)

January 2008 the ISK was worth .0111 EUR

October 2008 the ISK was worth .0033 EUR, a decrease in value of 70.5%

ISK = .008214 EUR on 10/5/14, a decrease in value of 26% compared with January 2008

Two Problems:

(1) Valuation Problem because the value of the assets were significantly below the deposits
and non-deposit funding plus equity.

(2) Liquidity Problem because companies in Iceland with the devaluation were more likely to
need to borrow more from Iceland’s banks at the same time that these banks were unable
to raise funds or raise them at a very high cost.