Chapter Eleven: Liquidity and Reserves Management Strategies and Policies

A financial firm is considered to be “liquid”

if it has ready to access to immediately spendable funds at reasonable cost at precisely the time those funds are needed.

This suggests that a liquid financial firm either has

• The right amount of immediately spendable funds on hand when they are required

• They can raise liquid funds in timely fashion by borrowing or selling assets

Demand for Liquidity

• Customer deposit withdrawals

• Credit requests from quality loan customers

• Repayment of non-deposit borrowings

• Operating expenses and taxes

• Payment of stockholder dividends

Demands on the Financial Firm for Liquidity

= Deposit Withdrawals - Volume of acceptable loan requests - Repayments of borrowings - Other operating expenses - Dividend payments to stockholders

Supplies of Liquid Funds

• Incoming customer deposits

• Revenues from the sale of non-deposit services

• Customer loan repayments

• Borrowings from the money market

Supplies of Liquidity Flowing into the Financial Statements = Incoming deposits + Revenues from the sale of non-deposit services + Customer Loan Repayments + Sales of assets + Borrowings from the money market

The essence of liquidity management problems for financial institutions

• Rarely are demands for liquidity equal to the supply of liquidity at any particular moment in time

  • The financial firm must continually deal with either a liquidity deficit or a liquidity surplus

• There is a trade-off between liquidity and profitability

  • The more resources are tied up in readiness to meet demands for liquidity, the lower is that financial firm’s expected profitability (other factors held constant)

Why Financial Firms Often 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

What is a liquid asset?

Liquid assets have a ready market, stable price and are reversible

Strategies for Liquidity Management

Asset Liquidity Management or Asset Conversion Strategy

• 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

Borrowed Liquidity or Liability Management Strategy

• This strategy calls for the bank to purchase or borrow from the money market to cover all of its liquidity needs

Balanced Liquidity Strategy

• The combined use of liquid asset holdings (Asset Management) and borrowed liquidity (Liability Management

Guidelines for Liquidity Managers

• Keep track of all fund-using and fund-raising departments

• Know in advance withdrawals by the biggest credit or deposit customers

• Priorities and objectives for liquidity management should be clear

• Liquidity needs must be evaluated on a continuing basis

Estimating Liquidity Needs

• Sources of Uses of Funds Approach

• Structure of Funds Approach

• Liquidity Indicator Approach

• The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace

Sources of Funds Approach

• Loans and deposits must be forecast for a given liquidity planning period

• The estimated change in loans and deposit 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.

• Estimated liquidity deficit (-) or surplus (+) for the coming period = Estimated change in deposits - Estimated changes in loans

Cash Position Indicator

Cash and Balances due from Depository Institutions/Total Assets

Liquid Securities Indicator

US Government Securities/Total Assets

Net Federal Funds and Repurchase Agreements Position

(Fed Funds Sold and Reverse Repurchase Agreements - Fed Funds Purchased and Repurchase Agreements) / Total Assets

Capacity Ratio

Net Loans and Leases / Total Assets

Pledged Securities Ratio

Securities Pledged to Back Government Deposits / Total Assets

Hot Money Ratio

(Cash and Due from Depository Institutions + Short Term Securities + Fed Funds Sold and Reverse Repurchase Agreements) / (Large CDs + Eurocurrency deposits + Fed Funds Borrowed and Repurchase Agreements)

Deposit Brokerage Index

Brokered Deposits/Total Deposits

Core Deposit Ratio

Core Deposit / Total Assets

Deposit Composition Ratio

Demand Deposits / Time Deposits

Loan Commitments Ratio

Unused Loan Commitments / Total Assets

Liquidity mangers should closely monitor the following market signals

• Public confidence

• Stock price behavior

• Risk premiums on CDs and other borrowings

• Loss of sales of assets

• Meeting commitments to credit customers

• Borrowings from the central bank

Legal Reserves

• Those assets that law and central bank regulation say must be held during a particular time period

• Only two kinds of assets can be used for this purpose

  • Cash in the vault

  • Deposits held in a reserve account with the regional Fed

Lagged Reserve Accounting (LRA)

The current system of accounting for legal reserves

• The daily average amount of deposits and other reservable liabilities are computed using information gathered over a two-week period stretching from a Tuesday through a Monday two weeks later

• This interval time is known as the reserve computation period

• The daily average amount of vault cash each depository institution holds is also figured over the same two-week computation period

Calculating Required Reserves

• The largest depository institutions must hold the largest percentage of legal reserves

• Each reserve liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement

Total required legal reserves = Reserve requirement on transaction deposits Daily average amount of net transaction deposits over the computation period + Reserve requirement on non-transaction reserve liabilities * Daily average amount of non-transaction reserve liabilities over the computation period.

Clearing Balances

In addition to holding a legal reserve account at the central bank, many depository institutions also hold a clearing balance with the Fed to cover checks or other debit items drawn against them

Controllable Factors Increasing Legal Reserves

• Selling securities

• Receiving interest payments on securities

• Borrowing reserves from the Federal Reserve Bank

• Purchasing Federal funds from other banks

• Selling securities under a repurchase agreement (RP)

• Selling new CDs, Eurocurrency deposits, or other deposits to customers

Noncontrollable Factors Increasing Legal Reserves

• Surplus position at the local clearinghouse due to receiving more deposited checks in its favor than checks drawn against it

• Credit from cash letter sent to the Fed, listing draft received by the bank

• Deposits made by the U.S Treasury into a tax and loan account held at the bank

• Credit received from the Federal Reserve bank for checks previously sent for collection (deferred availability items).

Controllable Factors Decreasing Legal Reserves

• Purchasing securities

• Making interest payments to investors holding the bank’s securities

• Repaying a loan from the Federal Reserve bank

• Selling Federal funds to other institutions in need of reserves

• Security purchase under a repurchase agreement (RP)

• Receiving currency and coin shipment from the Federal Reserve Bank

Noncontrollable Factors Decreasing Legal Reserves

• Deficit position at the local clearinghouse due to more checks drawn against the bank then in its favor

• Calls of funds from the bank’s tax and loan account by the U.S Treasury

Sweep Accounts

• Volume of legal reserves held at the Fed has declines in recent years largely due to swap accounts

• A contractual account between a bank and a 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

• The sweeps market is likely to change in form and importance due to the recent passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2009

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 Factors to Influence Legal Reserves

• Sell liquid securities

• Draw upon excess correspondent balances

• Enter into repurchase agreements for temporary borrowings

• Sell new time deposits

• Borrow from the Federal Home Loan Bank

• Borrow in the Eurocurrency market

Factors in Choosing among the Different Sources of Reserves

In choosing which source of reserves to draw upon to cover a legal reserve deficit, managers must carefully consider several aspects of their institution’s need for liquid funds:

• Immediacy of need

• Duration of need

• Access to the market for liquid funds

• Relative costs and risks of alternative sources of funds

• The interest rate outlook

• Outlook for central bank monetary policy

• Rules and regulations applicable to a liquidity source

Central Bank Reserve Requirements around the Globe

• Not all central banks impose legal reserve requirements on the depository institutions they regulate

  • For example, the Bank of England has not established official reserve requirements for its banks

  • There is a trend among central banks around the globe to eliminate, suspend, or at least make less use of the reserve requirement tool, in part because it is so difficult to control

  • A notable exception is the European Central Bank (ECB)

• Even if central banks imposed no reserve requirements, managers of depository institutions would still demand for cash reserves

  • All depository institutions at one time or another need immediately available funds to handle customer withdrawals, meet new loan demand, and satisfy other emergency cash needs