Liquidity Management

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Liquidity Management

  1. 1. Legal Reserves <ul><li>Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities </li></ul>
  2. 2. U.S. Legal Reserve Requirements <ul><li>First $7.8 Million have 0 Legal Reserves </li></ul><ul><li>3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $48.3 Million </li></ul><ul><li>10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $48.3 Million </li></ul><ul><li>Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments </li></ul><ul><li>The $48.3 Million Amount is Adjusted Annually </li></ul>
  3. 3. Sweep Account <ul><li>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 </li></ul>
  4. 4. Reserve Computation Period <ul><li>The Period of Time Over Which a Bank Calculates its Legal Reserve Requirement </li></ul>
  5. 5. Reserve Maintenance Period <ul><li>The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands </li></ul>
  6. 6. Factors in Choosing Among Different Sources of Reserves <ul><li>Immediacy of Bank’s Needs </li></ul><ul><li>Duration of Bank’s Needs </li></ul><ul><li>Bank’s Access to Market for Liquid Funds </li></ul><ul><li>Relative Costs and Risks of Alternatives </li></ul><ul><li>Interest Rate Outlook </li></ul><ul><li>Outlook for Central Bank Monetary Policy </li></ul><ul><li>Regulations Applicable for Liquidity Sources </li></ul>
  7. 7. Liquidity <ul><li>The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost </li></ul>
  8. 8. Supplies of Liquid Funds <ul><li>Incoming Customer Deposits </li></ul><ul><li>Revenues from the Sale of Nondeposit Services </li></ul><ul><li>Customer Loan Repayments </li></ul><ul><li>Sales of Bank Assets </li></ul><ul><li>Borrowings from the Money Market </li></ul>
  9. 9. Demands for Liquidity <ul><li>Customer Deposit Withdrawals </li></ul><ul><li>Credit Requests from Quality Loan Customers </li></ul><ul><li>Repayment of Nondeposit Borrowings </li></ul><ul><li>Operating Expenses and Taxes </li></ul><ul><li>Payment of Stockholder Dividends </li></ul>
  10. 10. A Financial Firm’s Net Liquidity Position <ul><li>L = Supplies of Liquid Funds </li></ul><ul><li>- Demands for Liquidity </li></ul>
  11. 11. Essence of Liquidity Management <ul><li>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 </li></ul><ul><li>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. </li></ul>
  12. 12. Why Banks and Their Competitors Face Significant Liquidity Problems <ul><li>Imbalances Between Maturity Dates of Their Assets and Liabilities </li></ul><ul><li>High Proportion of Liabilities Subject to Immediate Repayment </li></ul><ul><li>Sensitivity to Changes in Interest Rates </li></ul><ul><li>Central Role in the Payment Process </li></ul>
  13. 13. Strategies for Liquidity Managers <ul><li>Asset Liquidity Management or Asset Conversion Strategy </li></ul><ul><li>Borrowed Liquidity or Liability Management Strategy </li></ul><ul><li>Balanced Liquidity Strategy </li></ul>
  14. 14. Asset Liquidity Management <ul><li>This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed </li></ul>
  15. 15. Liquid Asset <ul><li>Must Have a Ready Market So it Can Be Converted to Cash Quickly </li></ul><ul><li>Must Have a Reasonably Stable Price </li></ul><ul><li>Must Be Reversible So an Investor Can Recover Original Investment with Little Risk </li></ul>
  16. 16. Options for Storing Liquidity <ul><li>Treasury Bills </li></ul><ul><li>Fed Funds Sold to Other Banks </li></ul><ul><li>Purchasing Securities for Resale (Repos) </li></ul><ul><li>Deposits with Correspondent Banks </li></ul><ul><li>Municipal Bonds and Notes </li></ul><ul><li>Federal Agency Securities </li></ul><ul><li>Negotiable Certificates of Deposits </li></ul><ul><li>Eurocurrency Loans </li></ul>
  17. 17. Costs of Asset Liquidity Management <ul><li>Loss of Future Earnings on Assets That Must Be Sold </li></ul><ul><li>Transaction Costs on Assets That Must Be Sold </li></ul><ul><li>Potential Capital Losses If Interest Rates are Rising </li></ul><ul><li>May Weaken Appearance of Balance Sheet </li></ul><ul><li>Liquid Assets Generally Have Low Returns </li></ul>
  18. 18. Borrowed Liquidity Management <ul><li>This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs </li></ul>
  19. 19. Sources of Borrowed Funds <ul><li>Federal Funds Purchased </li></ul><ul><li>Selling Securities for Repurchase (Repos) </li></ul><ul><li>Issuing Large CDs (Greater than $100,000) </li></ul><ul><li>Issuing Eurocurrency Deposits </li></ul><ul><li>Securing Advance from the Federal Home Loan Bank </li></ul><ul><li>Borrowing Reserves from the Discount Window of the Federal Reserve </li></ul>
  20. 20. Balanced Liquidity Management Strategy <ul><li>The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs </li></ul>
  21. 21. Guidelines for Liquidity Managers <ul><li>They Should Keep Track of All Fund-Using and Fund-Raising Departments </li></ul><ul><li>They Should Know in Advance Withdrawals by the Biggest Credit or Deposit Customers </li></ul><ul><li>Their Priorities and Objectives for Liquidity Management Should be Clear </li></ul><ul><li>Liquidity Needs Must be Evaluated on a Continuing Basis </li></ul>
  22. 22. Methods for Estimating Liquidity Needs <ul><li>Sources and Uses of Funds Approach </li></ul><ul><li>Structure of Funds Approach </li></ul><ul><li>Liquidity Indicator Approach </li></ul><ul><li>Signals from the Marketplace </li></ul>
  23. 23. Sources and Uses of Funds <ul><li>Loans and Deposits Must Be Forecast for a Given Liquidity Planning Period </li></ul><ul><li>The Estimated Change in Loans and Deposits Must Be Calculated for the Same Planning Period </li></ul><ul><li>The Liquidity Manager Must Estimate the Bank’s Net Liquid Funds By Comparing the Estimated Change in Loans to the Estimated Change in Deposits </li></ul>
  24. 26. Structure of Funds <ul><li>A Bank’s Deposits and Other Sources of Funds Divided Into Categories. For Example: </li></ul><ul><ul><li>‘ Hot Money’ Liabilities </li></ul></ul><ul><ul><li>Vulnerable Funds </li></ul></ul><ul><ul><li>Stable Funds </li></ul></ul><ul><li>Liquidity Manager Set Aside Liquid Funds According to Some Operating Rule </li></ul>
  25. 27. Customer Relationship Doctrine <ul><li>Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships </li></ul>
  26. 30. Liquidity Indicator Approach <ul><li>Cash Position Indicator </li></ul><ul><li>Liquid Security Indicator </li></ul><ul><li>Net Federal Funds Position </li></ul><ul><li>Capacity Ratio </li></ul><ul><li>Pledged Securities Ratio </li></ul><ul><li>Hot Money Ratio </li></ul><ul><li>Deposit Brokerage Index </li></ul><ul><li>Core Deposit Ratio </li></ul><ul><li>Deposit Composition Ratio </li></ul><ul><li>Loan Commitment Ratio </li></ul>
  27. 32. Market Signals of Liquidity Management <ul><li>Public Confidence </li></ul><ul><li>Stock Price Behavior </li></ul><ul><li>Risk Premiums on CDs </li></ul><ul><li>Loss Sales of Assets </li></ul><ul><li>Meeting Commitments to Creditors </li></ul><ul><li>Borrowings from the Central Bank </li></ul>
  28. 33. Examples <ul><li>The Double Trouble State Bank has incoming deposits of $2000, revenues from nondeposit services of $200, customer loan repayments of $1000, the sale of assets of $500 and borrowings from the money market of $2000. At the same time they had deposit withdrawals of $1500, acceptable loan requests of $1200, repayments of borrowings for the bank of $1000 and other operating expenses of $500. What is the net liquidity position of this bank? </li></ul><ul><ul><li>$1500 Surplus </li></ul></ul>
  29. 34. Examples <ul><li>A bank currently has $50 million in stable deposits against which they want to keep 10% reserves, $100 in vulnerable deposits against which they want to keep 40% reserves and they have $50 million in “hot money’ deposits against which they want to keep 90% reserves. The legal reserves for this bank are 10% of all deposits. What is this bank’s liability liquidity reserve? </li></ul><ul><ul><li>$81 million </li></ul></ul>
  30. 35. Examples <ul><li>John Camey, the money manager of the First State Bank, has estimated that the bank has a 20 percent chance of a liquidity deficit of $700, a 30 percent chance of a liquidity deficit of $200, a 30 percent chance of a liquidity surplus of $400 and a 20 percent chance of a liquidity surplus of $900 over the next week. What is this bank’s expected liquidity deficit or surplus over the next week? </li></ul><ul><ul><li>$100 liquidity surplus </li></ul></ul>
  31. 36. Examples <ul><li>A bank currently holds $105 million in transaction deposits subject to legal reserves but has managed to enter into sweep account arrangements affecting $55 million of these accounts. Given that the bank must hold 3 percent legal reserves up to $47.8 million of transaction deposits and 10 percent legal reserves on any amount above that, how much has this bank reduced its total legal reserves as a result of these sweep arrangements? </li></ul><ul><ul><li>$5.5 million </li></ul></ul>

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