1

Liquidity and Reserves

Management:
Strategies and Policies

Alvarez, Gladys Faith M.

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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
banks cash balance and liquidity position:
Deposits and withdrawals; loan
disbursements and loan payments
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11-3

Supplies of Liquid Funds

Incoming Customer Deposits
Revenues from the Sale of Non-deposit Services
Customer Loan Repayments
Sales of Bank Assets
Borrowings from the Money Market
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11-4

Demands for Liquidity

Customer Deposit Withdrawals
Credit Requests from Quality Loan
Customers
Repayment of Non-deposit Borrowings
Operating Expenses and Taxes
Payment of Stockholder Dividends

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11-5

A Financial Firms Net Liquidity

Position

L =

Supplies of Liquid Funds

- Demands for Liquidity

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11-6

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) Non-deposit 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.
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What is this banks projected net liquidity position for the coming
2008 The McGraw-Hill Companies, Inc., All Rights
Bank
Management and Financial
week?
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Hanna Gallendo
McGraw-Hill/Irwin
Bank Management and Financial

2008 The McGraw-Hill Companies, Inc., All Rights

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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 Firms
Expected Profitability.
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11-9

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
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11-10

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
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11-11

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
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11-12

Options for Storing Liquidity

Treasury Bills
Fed Funds Sold to
Other Banks
Purchasing Securities
for Resale (Repos)
Deposits with
Correspondent Banks

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Bank Management and Financial

Municipal Bonds and

Notes
Federal Agency
Securities
Negotiable Certificates of
Deposits
Eurocurrency Loans

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13

Joel San Juan

McGraw-Hill/Irwin
Bank Management and Financial

2008 The McGraw-Hill Companies, Inc., All Rights

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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
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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
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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
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11-17

Borrowed Liquidity (Liability)

Management Strategy
Advantages

Disadvantages

Borrow Only When There

is a Need for Funds
Highest Expected Return But
Volume and Composition
Carries the Highest Risk Due
to Volatility of Interest Rates
of the Investment Portfolio
and Possible Rapid Changes
Can Remain Unchanged
in Credit Availability
The Institution Can
Borrowing Cost is Always
Control Interest Rates in
Uncertain-> Uncertain
Order to Borrow Funds
Earnings
(raise offer rates when
Borrowing Needs Can Be
needs requisite amounts
Interpreted as a Signal of
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of
funds)
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Bank Management and Financial
Financial Difficulties

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18

Angelica Saphira Azarcon

Sandiego

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11-19

Balanced Liquidity Management

Strategy
The Combined Use of Liquid
Asset Holdings (Asset
Management) and Borrowed
Liquidity (Liability Management)
to Meet Liquidity Needs
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11-20

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11-21

Structure of Funds Approach

A Banks 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
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11-22

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

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23

Elvin Licmoan
McGraw-Hill/Irwin
Bank Management and Financial

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11-24

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

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11-25

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.

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11-26

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
Institutions Legal Reserve Account
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11-27

Calculating Required Reserves

Any deficit above 4% may be assessed an interest penalty equal to the Federal
Reserves 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.
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28

Mercie Ann Penafiel

McGraw-Hill/Irwin
Bank Management and Financial

2008 The McGraw-Hill Companies, Inc., All Rights

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11-29

Factors Influencing the Money Position

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11-30

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 Customers Checking Account
Overnight in Order to Generate Higher Returns
for the Customer and Lower Reserve
Requirements for the Bank
Retail Sweep
Business Sweep
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11-31

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
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11-32

Factors in Choosing Among

Different Sources of Reserves
Immediacy of Banks Needs
Duration of Banks Needs
Banks 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
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