LIQUIDITY & RESERVE

MANAGEMENT:
STRATEGIES & POLICIES

Chapter 6

1
William Chittenden edited and updated the PowerPoint slides for this edition.

7-2

Key topics

1. Liquidity: Supply and Demand

2. Liquidity management strategies

3. Estimating liquidity needs

4. Legal reserves and money position management

5. Factor in choosing reserve sources

1
 11-3

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:

➢ Deposits and withdrawals;

➢ Loan disbursements and loan payments

3

11-4

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

4

2
 11-5

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

5

11-6

3
 11-7

A financial firm’s net liquidity position

L = Supplies of liquid funds
- Demands for liquidity
▪ Liquidity deficit (L < 0)
▪ Liquidity surplus (L > 0)
▪ Time dimension of liquidity
➢ immediate liquidity (CD due to mature, deposit
withdrawn tomorrow)
➢ longer-term liquidity (arising from seasonal,
cyclical & trend factor)
→ manager must plan how, when & where liquid
fund can be raised 7

11-8

Quick quiz: Comprehensive problem

Suppose that a bank faces the following cash inflows and outflows during
the coming week:
1. Deposit withdrawals are expected to total $33 million;
2. Customer loan repayments are expected to amount to $108 million;
3. Operating expenses demanding cash payment will probably
approach $51 million;
4. Acceptable new loan requests should reach $294 million;
5. Sales of bank assets are projected to be $18 million;
6. New deposits should total $670 million;
7. Borrowings from the money market are expected to be about $43mil;
8. Non-deposit service fees should amount to $27 million;
9. Previous bank borrowings totaling $23mil are scheduled to be
repaid; &
10. A dividend payment to bank stockholders of $140 million is
scheduled. 8
What is this bank’s projected net liquidity position for the coming week?

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 11-9

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.
➢ High liquidity → high opportunity cost
➢ Low liquidity → high interest cost & transaction cost 9

11-10

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
➢ customer demand for loans
➢ cost to raise additional fund
▪ High reliance on public confidence for reputation 10

10

5
 11-11

Strategies for liquidity managers

1. Think about what is a liquid asset?

2. Identify strategies for liquidity management.

• Strategies include:

1. Asset liquidity management (Asset conversion)

2. Borrowed liquidity or liability management

3. Balanced liquidity management

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11

11-12

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.

▪ Mainly used by small financial institutions, finding

that reliance on borrowing is a risky approach.

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6
 11-13

Liquid asset characteristics

▪ 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 of loss

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13

11-14

Options for storing liquidity – why?

– read p. 364

1. Treasury bills 5. Municipal bonds and

notes
2. Fed funds sold to
other banks 6. Federal agency
securities
3. Purchasing securities
for resale (Repos) 7. Negotiable certificates
of deposits
4. Deposits with
correspondent banks 8. Eurocurrency loans

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7
 11-15

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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15

11-16

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.

▪ Applied by large financial institutions

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8
 11-17

Sources of borrowed funds - why?

– read p. 365
1. Federal funds purchased

2. Selling securities for repurchase (Repos)

3. Issuing large CDs (> $100,000)

4. Issuing Euro-currency deposits

5. Securing advance from the Federal Home Loan

Bank (FHLB)

6. Borrowing reserves from the discount window

17
of the Federal Reserve
17

11-18

Borrowed liquidity (liability) management strategy

Advantages Disadvantages
▪ Borrow only when there ▪ Highest expected return but
is a need for funds carries the highest risk due
▪ Volume and composition to volatility of interest rates
of the investment portfolio and possible rapid changes
can remain unchanged in credit availability
▪ The institution can control ▪ Borrowing cost is always
interest rates in order to uncertain → uncertain
borrow funds (raise offer earnings
rates when needs ▪ Borrowing needs can be
requisite amounts of interpreted as a signal of
funds) financial difficulties
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9
 11-19

Balanced liquidity management strategy

▪ The combined use of liquid asset holdings (Asset

management) and borrowed liquidity (Liability
management) to meet liquidity needs.
➢ Some expected demand for liquidity is stored in assets

➢ Some liquidity needs are backed by arranged credit line

from potential fund suppliers

➢ Unexpected cash needs are met by near-term borrowings

➢ Longer-term liquidity needs are planned and parked in

short-& medium-term assets 19

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11-20

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 20

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10
 11-21

Methods for estimating liquidity needs

▪ Sources and uses of funds approach

▪ Structure of funds approach

▪ Liquidity indicator approach

▪ Signals from the marketplace

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Reading:

◼ Content of each approach?

- Assumptions
- Content
- Applications

4 groups read in 10 minutes and present

shortly.

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 11-23
Sources and uses of funds
Key steps….

1. Loans and deposits must be forecast for a given

liquidity planning period

2. The estimated change in loans and deposits must

be calculated for the same planning period

3. The liquidity manager must estimate the bank’s net

liquid funds by comparing the estimated change in

loans to the estimated change in deposits.

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11-24

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 11-25
Sources and uses of funds
Simpler approach….
Forecast of future deposit and loan growth is divided
into 3 components:
1. Trend component: a trend with constant growth is
estimated based on data in a long period
2. Seasonal component: changes in deposit or loan
due to seasonal factors
3. Cyclical component: deviation from the bank’s
expected deposits & loans depending on strength or
weakness of the economy in the current year. 25

25

Forecasts of trend, seasonal, and cyclical

components of deposits and loans
Reference balance sheet:
Assets Liabilities
Transaction accounts and
Cash and due from banks $ 160 $1,600
nonnegotiable deposits
Certificates of deposit and other
Loans 1,400 280
borrowing
Investment securities 400 Stockholders' equity 120
Other assets 40 Total $2,000
Total $2,000

Average growth of deposits over 10-year-period: 12% annually or 0,95% monthly

Average growth of loans over 10-year-period: 9% annually or 0,72% monthly
26

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13
 Forecasts of trend, seasonal, and cyclical
components of deposits and loans
Deposit forecast
(3)
(2) Seasonal
Seasonal Deposits - (4)
End of Trend Deposit Dec. Cyclical (5)
Month Deposits lndext Deposits Deposits Total

January $1,615.18 99% $-16 $-3 $1,596.18

February 1,630.51 102 32 8 1,670.51
March 1,645.98 105 80 7 1,732.98
April 1,661.60 107 112 10 1,783.60
May 1,677.36 101 16 1 1,694.36
June 1,693.28 96 -64 -8 1,621.28
July 1,709.35 93 -112 -15 1,582.35
August 1,725.57 95 -80 -9 1,636.57
September 1,741.94 97 -48 -4 1,689.94
October 1,758.47 101 16 0 1,774.47
November 1,775.16 104 64 3 1,842.16
December 1,792.00 100 0 0 1,792.00
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27

Forecasts of trend, seasonal, and cyclical

components of deposits and loans
Loan forecast

Seasonal Seasonal
End of Trend Loan Loan- Cyclical
Month Loans* lndext Dec. Loans Loans Total

January $1,410.09 101% $14 $6 $1,430.09

February 1,420.25 97 -42 -9 1,368.95
March 1,430.49 95 -71 -18 1,341.48
April 1,440.80 94 -86 -21 1,333.97
May 1,451.18 97 -43 -15 1,392.96
June 1,461.64 102 29 -3 1,487.67
July 1,472.18 108 117 9 1,598.11
August 1,482.79 106 88 17 1,588.12
September 1,493.47 103 44 11 1,548.96
October 1,504.24 99 -15 5 1,494.30
November 1,515.08 98 -30 0 1,485.00
December 1,526.00 100 0 0 1,526.00

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 Monthly liquidity needs

▪ The bank’s monthly liquidity needs are

estimated as the forecasted change in loans
plus required reserves minus the forecast
change in deposits:

➢ Liquidity needs =
Forecasted Dloans + Drequired reserves -
forecasted Ddeposits
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Estimates of liquidity needs

End of DDeposits DRequired DLoans Liquidity

Month Reserves Needs*

January -3.82 1.1 30.09 -32.81

February 74.33 5.6 -61.14 141.07
March 62.47 11.0 -27.47 100.95
April 50.62 15.3 -7.51 73.43
May -89.23 5.6 58.99 -142.62
June -73.08 -2.5 94.71 -170.29
July -38.93 -7.2 110.44 -156.58
August 54.22 -2.6 -9.99 61.61
September 53.37 1.9 -39.16 94.43
October 84.53 9.6 -54.65 148.78
November 67.69 15.5 -9.31 92.49
December -50.16 9.6 41.00 -81.56
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 Sources and uses of funds
More simpler approach: Liquidity GAP measures
▪ Management can supplement this information
with projected changes in purchased funds and
investments with specific loan and deposit flows.
▪ The bank can calculate a liquidity GAP by
classifying potential uses and sources of funds
into separate time frames according to their cash
flow characteristics.
▪ The Liquidity GAP for each time interval equals
the dollar value of uses of funds minus the dollar
value of sources of funds.
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Liquidity gap estimates (millions of dollars)

0–30 Days 31–90 Days 91–365 Days
Potential Uses of Funds
Add: Maturing time deposits
Small time deposits 5.5 8.0 34.0
Certificates of deposit over $100,000 40.0 70.0 100.0
Eurodollar deposits 10.0 10.0 30.0
Plus: Forecast new loans
Commercial loans 60.0 112.0 686.0
Consumer loans 22.0 46.0 210.0
Real estate and other loans 31.0 23.0 223.0
Minus: Forecast net change in transactional accounts
Demand deposits - 6.5 105.5 10.0
NOW accounts 0.4 5.5 7.0
Money market deposit accounts 1.6 3.0 6.0
Total uses $173.0 155.0 1,260.0
Potential Sources of Funds
Add: Maturing investments
Money market instruments 8.0 16.5 36.5
U.S. Treasury and agency securities 7.5 10.5 40.0
Municipal securities 2.5 1.0 12.5
Plus: Principal payments on loans 80.0 262.0 903.0
Total sources 98.0 290.0 992.0
Periodic Liquidity GAP 75.0 -135.0 268.0
32
Cumulative Liquidity GAP 75.0 - 60.0 208.0

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 Potential funding sources (millions of dollars)
Time Frame
0–30 31–90 91–365
Days Days Days
Purchased Funds Capacity
Federal funds purchased (overnight and term) $20 $20 $30
Repurchase agreements 10 10 10
Negotiable certificates of deposit
Local 50 50 60
National 20 20 25
Eurodollar certificates of deposit 20 20 20
Total $120 $120 $145
Additional Funding Sources
Reductions in federal funds sold $5 $5 $5
Loan participations 20 20 20
Sale of money market securities 5 5 5
Sale of unpledged securities 10 10 10
Total $40 $40 $40
Potential Funding Sources $160 $160 $185
Potential Extraordinary Funding Needs
50% of outstanding letters of credit 5 10 15
20% of unfunded loan commitments 25 30 35
Total $30 $40 $50
33

Excess Potential Funding Sources $130 $120 $135

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11-34

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

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17
 Structure of funds approach
Liability liquidity reserve =
0.95 x (Hot money deposit & non-deposit funds –
Legal reserves held)

+ 0.30 x (Vulnerable deposit & non-deposit funds

– Legal reserves held)

+ 0.15 x (Stable deposit & non-deposit funds –

Legal reserves held)
Note: 0.95, 0.30, 0.15: common rule of thumb 35

35

Structure of funds approach

Total liquidity requirement
= Deposit & non-deposit liability liquidity
requirement and Loan liquidity requirement
= 0.95 x (Hot money funds – Legal reserves held
behind hot money deposits)
+ 0.30 x (Vulnerable deposit & non-deposit funds –
Required legal reserves)
+ 0.15 x (Stable deposit & non-deposit funds –
Required legal reserves)
+ 1.00 x (Potential loans outstanding – Actual loans
outstanding)
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18
 11-37

Liquidity indicator approach

(based on experience and industry averages) –
p. 374-375
6. Capacity ratio
1. Cash position indicator

7. Pledged securities ratio

2. Liquid security indicator

8. Deposit brokerage index

3. Net Fed funds position

9. Deposit composition ratio

4. Hot money ratio

10. Loan commitment ratio

5. Core deposit ratio
The higher ratio → the less liquid
The higher ratio → the more liquid
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11-38

Trend of selected liquidity indicators

1. Table 11.4 – p.375

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 11-39
The ultimate standard: market signals
of liquidity management
1. Public confidence

2. Stock price behavior

3. Risk premiums on CDs

4. Loss sales of assets

5. Meeting commitments to creditors

6. Borrowings from the central bank

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For discussions

◼ Read two cases: p 372 and p. 377

◼ Can you name some liquidity crises in the
world and in Vietnam?

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 11-41

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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Reserve balances at the Federal Reserve Bank

▪ Banks hold deposits at the Federal Reserve

because:
➢ The Federal Reserve imposes legal reserve
requirements and deposit balances qualify as legal
reserves

➢ To help process deposit inflows and outflows

caused by check clearings, maturing time deposits
and securities, wire transfers, and other
transactions 42

42

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 Reserve balances at the Federal Reserve Bank

▪ Required reserves and Monetary policy

➢ The purpose of required reserves is to enable the
Federal Reserve to control the nation’s money
supply

➢ The Fed has three distinct monetary policy tools:

◼ Open market operations

◼ Changes in the discount rate

◼ Changes in the required reserve ratio

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Reserve balances at the Federal Reserve Bank

▪ Required reserves and Monetary policy

➢ Changes in reserve requirements directly

affect the amount of legal required reserves
and thus change the amount of money a bank
can lend out.

44

44

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 Reserve balances at the Federal Reserve Bank

▪ Required reserves and Monetary policy

➢ For example, a required reserve ratio of 10%
means that a bank with $100 in demand deposits
outstanding must hold $10 in legal required
reserves in support of the DDAs
◼ The bank can thus lend out only 90% of its DDAs
➢ If the bank has exactly $10 in legal reserves, the
reserves do not provide the bank with liquidity
◼ If the bank has $12 in legal reserves, $2 is excess
reserves, providing the bank with $2 in immediately
available funds 45

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11-46

Reserve balances at the Federal Reserve Bank

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: involving checking & saving accounts
of individual & families
➢ Business sweep: involving commercial checking
deposits 46

46

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 Reserve balances at the Federal Reserve Bank

▪ Impact of Sweep accounts on required reserve

balances
➢ Under Reg. D, banks have reserve requirements
of 10% on demand deposits, ATS, NOW, and
other checkable deposit (OCD) accounts
➢ MMDAs are considered personal saving deposits
and have a zero required reserve requirement
ratio.
➢ Sweep accounts are accounts that enable
depository institutions to shift funds from OCDs,
which are reservable, to MMDAs or other
accounts, which are not reservable 47

47

Growth of Sweep Transaction Deposits into

MMDAs: 1994–2004

700

Monthly Averages of Initial Amounts Cumulative Total

600

500
.
Billions of Dollars

400

300

200

100

0 48

Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04

48

24
 Reserve balances at the Federal Reserve Bank

▪ Sweep accounts: 2 types

➢ Weekend program
◼ Reclassifies transaction deposits as savings
deposits at the close of business on Friday
and back to transaction accounts at the open
on Monday

◼ On average, this means that for three days

each week, the bank does not need to hold
reserves against those balances 49

49

Reserve Balances at the Federal Reserve Bank

▪ Sweep accounts: 2 types

➢ Threshold account
❖ The bank’s computer moves the customer’s

DDA balance into an MMDA when the dollar

amount reaches some minimum and returns
funds as needed
❖ The number of transfers is limited to 6 per
month, so the full amount of funds must be
moved back into the DDA on the sixth transfer
of the month
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50

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 Meeting legal reserve requirements

▪ Required reserves can be met over a two-week

period

▪ There are three elements of required reserves:

➢ The dollar magnitude of base liabilities

➢ The required reserve fraction

➢ The dollar magnitude of qualifying cash assets

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Meeting legal reserve requirements

▪ Historical problems with reserve requirements

➢ Historically, reserve requirements varied with the
type of bank charter and each bank’s geographic
location

➢ Currently, banks use a lagged reserve account

(LRA) system
❖ Reserves are held for a two-week period against
deposit liabilities held for the two-week period
ending almost three weeks earlier 52

52

26
 Meeting legal reserve requirements

▪ Lagged reserve accounting

➢ Computation Period
◼ Consists of two one-week reporting periods
beginning on a Tuesday and ending on the
second Monday thereafter

➢ Maintenance Period
◼ Consists of 14 consecutive days beginning on a
Thursday and ending on the second Wednesday
thereafter 53

53

Meeting Legal Reserve Requirements

▪ Lagged reserve accounting

➢ Reserve balance requirements
◼ The balance to be maintained in any given
maintenance period is measured by:
❖ Reserve requirements on the reservable liabilities
calculated as of the computation period that ended
17 days prior to the start of the maintenance period

❖ Less vault cash as of the same computation period

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 Meeting legal reserve requirements

▪ Lagged reserve accounting

➢ Reserve balance requirements

❖ Both vault cash and Federal Reserve
Deposits qualify as reserves

❖ The portion that is not met by vault cash is

called the reserve balance requirement

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11-56

U.S. legal reserve requirements

▪ In 2007-2008, first $9.3mil have 0 legal reserves
▪ 3% of end-of-the-day daily average for a two week
period for transaction accounts up to $43.9mil ($43.9mil
is known as the reserve tranche and changes every
year)
▪ 10% of end-of-the-day daily average for a two week
period for transaction accounts for amounts over
$43.9mil
▪ Transaction accounts include checking accounts, NOW
accounts and other deposits used to make payments
▪ The $43.9mil amount is adjusted annually
▪ The money position manager oversees the institution’s
legal reserve account 56

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 Reserve Requirement Percentages for
Depository Institutions

Effective Date
of Applicable
Type of Deposit Percentage Percentages
Net transactions accounts
Exempt amt. $ 7.0 mill 0.0% 12/23/2004
Up to $ 47.6 mill 3.0% 12/23/2004
Over $ 47.6 mill 10.0% 12/23/2004
All other liabilities 0.0% 12/27/1990

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11-58

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.
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 Vietnam case

◼ Calculation and storage of the required reserve

- Decision No. 581/2003/QD-NHNN of June 09,
2003, promulgating the regulation on
compulsory reserves applicable to credit
institutions
- Circular No. 36/2014/TT-NHNN dated
December 20,2014 of the State Bank of
Vietnam stipulating prudential ratios in
operations of credit institutions

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59

Relationship between the Reserve maintenance

and Base computation periods under Lagged
reserve accounting
Sun Mon Tue Wed Thu Fri Sat

8-Aug 9-Aug 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug

15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug

22-Aug 23-Aug 24-Aug 25-Aug 26-Aug 27-Aug 28-Aug

29-Aug 30-Aug 31-Aug 1-Sep 2-Sep 3-Sep 4-Sep

5-Sep 6-Sep 7-Sep 8-Sep 9-Sep 10-Sep 11-Sep

12-Sep 13-Sep 14-Sep 15-Sep 16-Sep 17-Sep 18-Sep

19-Sep 20-Sep 21-Sep 22-Sep 23-Sep 24-Sep 25-Sep

Lagged reserve computation period and vault cash application period

60
Reserve maintenance period

60

30
 Report of reversible liabilities and
offsetting asset balances
Balances at Close of Business Day (millions of dollars)
Lagged Computation Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun Mon Two-
Week Daily
Period 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug 15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug 22-Aug 23-Aug Total Average
DDAs 992 995 956 954 954 954 989 996 960 959 958 958 958 990 $ 13,573 $ 969.50
Auto trans from savings 0 0 0 0 0 0 0 0 0 0 0 0 0 0 $ 0.0 $ 0.0
NOW and Super NOW 221 221 222 223 223 223 223 224 225 225 225 225 225 225 $ 3,130 $ 223.57
Deductions: $ 0.0 $ 0.0
DD bal from U.S. dep. 163 281 190 186 186 186 159 159 274 178 182 182 182 164 $ 2,672 $ 190.86
CIPC 96 96 78 78 78 78 95 98 92 79 81 81 81 88 $ 1,199 $ 85.64
Net trans. accounts 954 839 910 913 913 913 958 963 819 927 920 920 920 963 $ 12,832 $ 916.57

Vault Cash 28 30 31 33 33 33 38 30 31 32 32 32 32 36 $ 451 $ 32.21

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61

Required Reserves Report, August 10–23

Daily Avg. Daily Avg.
Deposit Reserve Requirement
Reservable Liabilities for Liab. ($mill) Percentage ($ mill)
Aug 10–23
Net trans. accounts
Exempt up to $ 7.0 mill 7.00 0.0% $0.000
Over 7 up to $ 47.6 mill $ 40.60 3.0% $1.218
Over $ 47.6 mill $ 868.97 10.0% $86.897
Total $ 916.57
Gross reserve requirement $88.115
Daily average vault cash $32.214
Net reserve requirement $55.901
Reserve carry-forward (from prior period) ($ 2.276)
Minimum reserves to be maintained with Federal Reserve $58.177
Maximum reserves to be maintained $61.702
(0.04 x 88.115) + 58.177

If a surplus carry forward of $ 1.500

Minimum reserves to be maintained with Federal Reserve $54.401
Carry forward (4% of gross reserve requirement) $3.525
Maximum reserves to be maintained $57.926
62
(0.04 x 88.115) + 54.401

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 11-63

Factors influencing the money position

63

63

11-64

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 64

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 11-65

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 65

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11-66

Quick quiz

1. What are the principal differences among asset

liquidity management, liability management, and
balanced liquidity management?
2. What guidelines should management keep in
mind when it manages a financial firm’s liquidity
position?
3. What is money position management?
4. What is the principal goal of money position
management?
5. What factors should a money position manager
consider in meeting a deficit in a depository
institution’s legal reserve account? 66

66

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 Questions & Problems

1. When is a financial institution adequately liquid?

2. What are the principal differences among asset liquidity
management, liability management, and balanced liquidity
management?
3. What is money position management? What is the
principal goal of money position management?
4. What are clearing balances? Of what benefit can clearing
balances be to a depository that uses the Federal
Reserve System’s check-clearing network?
5. Problem 3, 4, 5 and 10 (page 390-91)
67

67

Answers

1. When is a financial institution adequately liquid?

❖ A financial institution is adequately liquid if it has adequate

cash available precisely when cash is needed at a
reasonable cost.

❖ Management can monitor the cash position over time, and

also monitor what is happening to its cost of funds.

❖ One indicator of the liquidity adequacy is its cost - a rising

interest cost may reflect greater perceived risk for the
borrowing bank as viewed by capital-market investors.

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34
 Answers

2. What are the principal differences among asset liquidity

management, liability management, and balanced liquidity
management?
❖ Asset management is a strategy for meeting liquidity needs, used

mainly by smaller banks, in which liquid funds are stored in readily

marketable assets that can be quickly converted into cash as needed.

❖ Liability management involves borrowing enough immediately

spendable funds to cover demands for liquidity made against a bank.

❖ Balanced liquidity management calls for using both asset management

and liability management to cover a bank's liquidity needs.

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3. What is money position management? What is the

principal goal of money position management?
❖ Money position management is the management of a financial
institution’s liquidity position that requires quick decisions which may
have long-run consequences on profitability.
❖ Most large depository institutions have designated an officer of the firm
as money position manager, whose responsibility is to ensure that the
institution maintains an adequate level of legal reserves.
❖ The money-position management’s goal is to ensure that the bank has
sufficient legal reserves to meet its reserve requirements as imposed
by the central bank and holds not more than the minimum legal
requirement because excess legal reserves yield no income.

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4. What are clearing balances? Of what benefit can clearing

balances be to a depository that uses the Federal
Reserve System’s check-clearing network?
❖ Any financial institution using the Federal Reserve check
clearing system has to maintain a minimum balance with the
Federal Reserve, which is determined by its estimated check
clearing needs and its recent record of overdrafts.
❖ The clearing balance can be a benefit because the institution
earns credits from holding this balance with the Fed and this
credit can be used to pay the fees the Fed charges for services.

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5. Problem 3 (page 390)

Change Change
Month Total from Total from Source Use Net
Deposits Previous Loans Previous
Month Month

January 670 ---- 810 ----

February 615 -55 880 +70 0 125 -125

March 600 -15 910 +30 0 45 -45

April 575 -25 875 -35 35 25 +10
May 570 -5 870 -5 5 5 0
June 570 0 900 +30 0 30 -30
July 615 +45 875 -25 70 0 +70
August 615 +0 825 -50 50 0 +50

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5. Problem 3 (page 390)

Liquidity deficits can be met by:
1. aggressive advertising to attract NOW deposits,
2. issuing negotiable CDs in the money market,
3. if they have a holding company, the holding company could sell
commercial paper and pass the proceeds through to the bank
subsidiary,
4. borrowing Federal funds,
5. borrowing from the Federal Reserve district bank (although this is not
a likely alternative for most banks),
6. selling securities under agreements to repurchase,
7. selling some of their loans,
8. selling some of their securities, or
9. a combination of a number of these alternatives.

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5. Problem 3 (page 390)

Liquidity surpluses afford the bank the opportunity to:
1. aggressively pursue new loans,
2. invest in various money market instruments, such as Treasury
securities, or,
3. a combination of these alternatives.

Since both periods are relatively short lived, the bank should opt
for more temporary measures, that is, use of the money market.
However, if their longer-term forecasts hold promise for
continued growth, they may well want to develop strategies for
attracting more deposits and loans, as well.

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5. Problem 4 (page 390)

Checkable Savings Nonpersonal
Source deposits deposits time deposits Totals
Hot money $10 5 1,200 1,215
funds
Vulnerable 65 152 740 957
funds
Stable (core) 85 450 172 707
funds
Totals 160 607 2,112 2,879

Deposit Liquidity Requirement = 0.85 [Net "Hot Money" Funds]

+ 0.25 [Net Vulnerable Funds]
+ 0.05 [Net "Core" Funds]

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5. Problem 4 (page 390)

a) Net hot money funds = [10 – (10 * 0.03)] + [5] + [1,200]
= 9.7 + 5 + 1,200 = 1,214.7 million

b) Net vulnerable funds = [65 – (65 * 0.03)] + [152] + [540]

= 63.05 + 152 + 540 = 755.05 million

c) Net core funds = [85 – (85 * 0.03)] + [450] + [172]

= 82.45 + 450 + 172 = 704.45 million
→ Deposit liquidity requirement
= 0.85 * 1,214.7 + 0.25 * 755.05 + 0.05 * 704.45
= 1,032.495 + 188.7625 + 35.2225 = 1,256.48 million

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5. Problem 4 (page 390)

Total liquidity requirement = additional loan demand + deposit liquidity
requirement
Recent experience: Currently, loans total $2,500 million, but recently have
been as high as $2,550 million, or an additional $50 million.
Historically (based on past 3 years), annual loan growth has averaged 6%
Anticipated additional loan demand (low estimate) = $2,500 * 1.06 = $2,650
million
Anticipated additional loan demand (high estimate) = $2,550 * 1.06 = $2,703
million
Therefore, additional loan demand could range from $150 million (= 2,650 –
2,500) to as much as $153 million (= 2,703 – 2,550) .
Total liquidity requirement (low estimate) = $1,256 + $150 = $1,406 million.
Total liquidity requirement (high estimate) = $1,256 + $153 = $1,409 million.

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5. Problem 5 (page 390)

Indicator Most Recent Year Previous Year
1 Cash position indicator 345,000/3,500,000 358,000/3,250,000
Cash and due from
banks/Total assets = 0.0986 = 0.1102
2 Liquid securities indicator 176,000/3,500,000 178,000/3,250,000
U.S. Govt. sec. / Total assets = 0.0503 = 0.0548
3 Net federal funds position (175,000- (131,000-237,000)/3,250,000
217,000)/3,500,000
(Fed funds sold-Fed funds
purchased) /Total Assets = -0.012 = -0.0326
4 Capacity ratio 2,148,000/3,500,000 1,948,000/3,250,000
Net loans and leases/Total = 0.6137 = 0.5994
assets
5 Pledged security ratio 287,000/515,000 223,000/521,000
Pledged securities/Total = 0.557 = 0.428
securities

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 LIQUIDITY & RESERVE
MANAGEMENT:
STRATEGIES & POLICIES

Chapter 6

79
William Chittenden edited and updated the PowerPoint slides for this edition.

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