Discussion Topic

Chapter Name: Liquidity & Reserve Management:

Strategies and Policies

• Liquidity & its Essence

• Supplies & Demands of Liquid Funds
• Why Banks and Their Competitors Face Significant Liquidity
Problems?
• Strategies for Liquidity Managers
• Guidelines for Liquidity Managers
• Methods for Estimating Liquidity Needs
• Reserves
• Daily Statement of Statutory Liquidity Reserve

Book Reference: Peter S. Rose and A. R Khan

 Liquidity & its Essence
• The availability of cash in the amount and at the time needed at a
reasonable cost is regarded as Liquidity.

• A Financial Firm’s Net Liquidity Position (L)

L = Supplies of Liquid Funds - Demands for Liquidity

• 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.
 Supplies & Demands of Liquid Funds
Supplies
 Incoming Customer Deposits
 Revenues from the Sale of Non-
deposit Services
 Customer Loan Repayments
 Sales of Bank Assets
 Borrowings from the Money
Market
Demand
• Customer Deposit Withdrawals
• Credit Requests from Quality
Loan Customers
• Repayment of Non-deposit
Borrowings
• Operating Expenses and Taxes
• Payment of Stockholder
Dividends
 Why Banks and Their Competitors Face Significant
Liquidity Problems
 Maturity Mismatch:
Imbalances Between Maturity Dates of Their Assets and Liabilities:

 High Proportion of Liabilities Subject to Immediate Repayment:

Festive occasion, Seasonal fluctuation, Need to pay credit limit/ Demand
deposit, Online banking. Thus, banks must always stand ready to meet
immediate cash demands that can be substantial at times.

 Sensitivity to Changes in Interest Rates:

When interest rate rise, some depositors will withdraw their funds in
search of higher returns elsewhere. Many loan customers may postpone
new loan requests or speed up their drawings on those credit line that
carry lower interest rate. Thus, changing interest rate affect both
customer demand for deposits and customer demand for loans that has
impact on liquidity.
 Strategies for Liquidity Managers

 Asset Liquidity Management or Asset Conversion Strategy

 Borrowed Liquidity or Liability Management Strategy
 Balanced Liquidity Strategy
Asset Liquidity Management/ Asset Conversion Strategy
 This Strategy Calls for Storing Liquidity in the Form of Liquid Assets
and Selling Them When Liquidity is Needed. The following are the
options of liquidity:
➢ Treasury Bills
➢ Purchasing Securities for Resale (Repos)
➢ Deposits with Correspondent Banks
➢ Federal fund loan to other institutions
➢ Municipal Bonds and Notes
➢ Federal Agency Securities
➢ Negotiable Certificates of Deposits
➢ Eurocurrency Loans
Asset Liquidity Management/ Asset Conversion Strategy
 Conditions for a 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 that an Investor Can Recover Original Investment
with Little Risk

 Cost of Asset Liquidity Management

➢ Loss of Future Earnings on Assets, i.e., Opportunity cost
➢ Transaction Costs on Assets i.e., commission paid to security broker
➢ Potential Capital Losses since asset sometimes are sold at declining
prices.
➢ May Weaken Appearance of Balance Sheet by selling asset.
➢ Acquiring Liquid Assets Generally provide Low Returns
 Liability Management Strategy
 This Strategy Calls for the Bank to Purchase or Borrow from the
Money Market To Cover All of Its Liquidity Needs.

 Sources of Borrowed Funds

➢ Funds borrowings from easily accessible other bank or money
market lenders.
➢ Selling liquid, low risk Securities under a Repurchase (Repos)
agreement.
➢ Issuing Large CDs (Greater than $100,000) to major corporations or
to wealthy individuals.
➢ Issuing Eurocurrency Deposits to multinational banks and other
corporations at competitive market rate.
➢ Borrowing Reserves from the Discount Window of the central bank
 Balanced Liquidity Strategy
 The Combined Use of Liquid Asset Holdings (Asset Management) and
Borrowed Liquidity (Liability Management) to Meet Liquidity Needs.

 Under a balanced liquidity management strategy, some of the

expected demands for liquidity are stored in assets (principally
holdings of marketable securities), while other anticipated liquidity
needs are backstopped by advanced arrangements for lines of credit
from potential suppliers of funds.

 Unexpected cash needs are typically met from near-term borrowings

and longer-term liquidity needs can be planned for and the funds to
meet these needs can be parked in short-term and medium-term
assets that will provide cash as those liquidity needs arise.
 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
 Methods for Estimating Liquidity Needs

 Sources and Uses of Funds Approach

 Structure of Funds Approach
 Liquidity Indicator Approach
 Signals from the Marketplace
 Sources and Uses of Funds Approach
Key steps in the sources and uses of funds approach:

 Loans and Deposits Must Be Forecasted for a Given Liquidity Planning

Period
 The Estimated Change in Loans and Deposits 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
 Sources and Uses of Funds Approach
There are three approaches for estimating future deposits and loans.

 A trend component, estimated by constructing a trend (constant-

growth) line using as reference points year-end, quarterly, or monthly
deposit and loan totals established over at least the last 10 years (or
some other base period sufficiently long to define a trend growth rate).
 A seasonal component, measuring how deposits (or other funds
sources) and loans (or other funds uses) are expected to behave in any
given week or month due to seasonal factors, as compared to the most
recent year-end deposit or loan level.
 A cyclical component, representing positive or negative deviations
from a bank’s total expected deposits and loans (measured by the sum
of trend and seasonal components), depending upon the strength or
weakness of the economy in the current year.
Sources and Uses of Funds Approach
Sources and Uses of Funds Approach
 Structure of Funds Approach
Steps of Calculation of SF Approach

First Step: A Bank’s Deposits and Other Sources of Funds Divided Into
Categories. For Example:
‘Hot Money’ Liabilities: deposits and other funds (such as federal fund)
that are very interest sensitive or that management is sure will be withdrawn
during the current period.
Vulnerable Funds: customer deposits of which a substantial portion
,perhaps 25 or 30 percent ,will probably be removed from the bank sometime
during the current time period.
Stable Funds: core deposit or core liabilities which remain unchanged.

Second Step: Liquidity Manager Set Aside Liquid Funds/ According to Some
Operating Rule, Such as
 Hot money liability-95%
 Vulnerable fund-30%
 Stable fund-15%
The rate might be changed based on the banks policy also.
Structure of Funds Approach
Structure of Funds Approach
 Structure of Funds Approach
 Many financial firms like to use probabilities in deciding how much
liquidity to hold.
 Under this refinement of the structure of funds approach, the liquidity
manager will want to define the best and the worst possible liquidity
positions his or her financial institution might find itself in and assign
probabilities to each. For example:

 The worst possible liquidity position

 The best possible liquidity position

 Financial firms like to calculate their expected liquidity requirement,

based on the probabilities they assign to different possible outcomes
Structure of Funds Approach
 Structure of Funds Approach
 The management sees the worst possible situation next week as one
characterized by a $550 million liquidity deficit, but this least desirable
outcome is assigned a probability of only 10%, a $700 million defincit with
a probability of 40%, a $230 million surplus with probability of 30% and
$425 million surplus with 20% assigned probability. What, then, is the
institution’s expected liquidity requirement?

 Solution:

Bank’s Expected Liquidity Requirement= (.10*-550) million + (.40*-700)

million + (.30*230) million +
(.20*425) million
= -$181 Million
 Liquidity Indicator Approach
Many financial-service institutions estimate their liquidity needs based
upon experience and industry averages. This often means using certain
liquidity indicators . For example, for depository institutions the following
liquidity indicator ratios are often useful:
Cash position indicator: Cash and deposits due from depository
institutions/total assets, where a greater proportion of cash implies the
institution is in a stronger position to handle immediate cash needs.
Liquid securities indicator: U.S. government securities/total assets, which
compares the most marketable securities an institution can hold with the
overall size of its asset portfolio; the greater the proportion of government
securities, the more liquid the depository institution’s position tends to be.
Net federal funds and repurchase agreements position: (Federal funds
sold and reverse repurchase agreements-Federal funds purchased and
repurchase agreements)/total assets, which measures the comparative
importance of overnight loans relative to overnight borrowings of reserves;
liquidity tends to increase when this ratio rises.
Capacity ratio: Net loans and leases/total assets, which is really a negative
liquidity indicator because loans and leases are often the most illiquid of
assets.
 Liquidity Indicator Approach
Pledged securities ratio: Pledged securities/total security holdings, also a
negative liquidity indicator because the greater the proportion of securities
pledged to back government deposits, the fewer securities are available to
sell when liquidity needs arise.

Hot money ratio: Money market (short-term) assets/ Money market

Liabilities
Money Market Assets = Cash and due from deposits held at other depository
institutions + holdings of short-term securities + Federal funds + loans
reverse repurchase agreements)

Money Market Liabilities= (large CDs + Eurocurrency deposits + Federal

funds borrowings + repurchase agreements),

Hot money ratio reflects whether the institution has roughly balanced the
volatile liabilities it has issued with the money market assets it holds that
could be sold quickly to cover those liabilities.
 Liquidity Indicator Approach
Pledged securities ratio: Pledged securities/total security holdings, also a
negative liquidity indicator because the greater the proportion of securities
pledged to back government deposits, the fewer securities are available to
sell when liquidity needs arise.

Hot money ratio: Money market (short-term) assets/ Money market

Liabilities
Money Market Assets = Cash and due from deposits held at other depository
institutions + holdings of short-term securities + Federal funds + loans
reverse repurchase agreements)

Money Market Liabilities= (large CDs + Eurocurrency deposits + Federal

funds borrowings + repurchase agreements),

Hot money ratio reflects whether the institution has roughly balanced the
volatile liabilities it has issued with the money market assets it holds that
could be sold quickly to cover those liabilities.
 Liquidity Indicator Approach
Deposit brokerage index: Brokered deposits/total deposits,
where brokered deposits placed by securities brokers for their customers
with institutions paying the highest yields. Brokered deposits are interest
sensitive and may be quickly withdrawn; the more a depository institution
holds, the greater the chance of a liquidity crisis.

Core deposit ratio: Core deposits/total assets,

where core deposits include total deposits less all deposits over $100,000.
Core deposits are primarily small-denomination checking and savings
accounts that are considered unlikely to be withdrawn on short notice and so
carry lower liquidity requirements.

Deposit composition ratio: Demand deposits/time deposits,

where demand deposits are subject to immediate withdrawal via check
writing, while time deposits have fixed maturities with penalties for early
withdrawal. This ratio measures how stable a funding base each institution
possesses; a decline suggests greater deposit stability and a lesser need for
liquidity
 Liquidity Indicator Approach
Loan commitments ratio: Unused loan commitments/total assets,
which measures the volume of promises a lender has made to its customers
to provide credit up to a prespecified amount over a given time period. The
lender must be prepared with sufficient liquidity to accommodate a variety
of “take-down” scenarios that borrowers may demand. A rise in this ratio
implies greater future liquidity needs.
 Liquidity Indicator Approach- Excercises
First National Bank posts the following balance sheet entries on today’s date:
Net loans and leases, $3,502 million; cash and deposits held at other banks,
$633 million; Federal funds sold, $48 million; U.S. government securities,
$185 million; Federal funds purchased, $62 million; demand deposits, $988
million; time deposits, $2,627 million; and total assets, $4,446 million. How
many liquidity indicators can you calculate from these figures?

Solution: 5 ratios we can consider here

1. Cash Position Indicator: 0.14
2. Liquid Securities Indicator: 0.04
3. Net Federal Funds Position: -0.003
4. Capacity Ratio: 0.79
5. Deposit Composition Ratio: 0.38
 Market Signals of Liquidity Management
 Public Confidence: Is there evidence the bank is losing deposits, because
individual and institutions believe that there is some danger, it will run out of cash and be
unable to pay it obligations?

 Stock Price Behavior: Is the bank’s stock price falling because investors perceive
the bank has an actual or pending liquidity crisis?

 Risk Premiums on CDs: Is the market imposing a risk premium in the form of
higher borrowing costs because it believes the bank is headed for a liquidity crisis?

 Loss Sales of Assets: Has the bank recently been forced to sell assets in a hurry,
with significant losses, in order to meet demand for liquidity?

 Meeting Commitments to Creditors: Has the bank been able to honor all
reasonable and potential profitable requests for loans form its valued customers. Or have
liquidity pressures compelled management to turn down some otherwise acceptable loan
applications?

 Borrowings from the Central Bank: Has the bank been forced to borrow in
larger volume and more frequently from the central bank its home territory lately? Have
central bank official begun to question the bank’s borrowings?
If the answer to any of these question is yes, Management need to take a close look at its
liquidity management policies and practices to determine whether changes are in order.
 Legal Reserves and Money Position Management
 Management of liquidity position can be a harrowing job, requiring quick
decisions that may have long-run consequences for profitability.
 Most large depository institutions have designated an officer of the firm as
money position manager.
 Legal reserves refer assets the law and central bank regulation say must be
held in support of the institution’s deposits.
 In the United States, only two kinds of assets can be used for this purpose:
(1) cash in the vault; and (2) deposits held in a reserve account at the
Federal Reserve bank in the region
 Calculating Reserve Requirement
 The largest depository institutions must hold the largest percentage of legal
reserves, reflecting their great importance as funds managers for
themselves and for hundreds of smaller financial institutions.
 The total required legal reserves of each depository institution are figured
by the same method. Each reservable liability item is multiplied by the
stipulated reserve requirement percentage to derive each depository’s total
legal reserve requirement. Thus:
 Calculating Reserve Requirement
 Once a depository institution determines its required reserve amount, it
compares this figure to its actual daily average holdings of legal reserve
assets—vault cash and its reserve deposit at the central bank.
 If total legal reserves held are greater than required reserves, the depository
institution has excess reserves. Management will move quickly to invest the
excess because excess reserves pay no interest.
 If, on the other hand, the calculated required reserve figure exceeds the
amount of legal reserves actually held on a daily average basis, the
depository institution has a reserve deficit. The law requires the institution
to cover this deficit by acquiring additional legal reserves. There remains a
penalty for the failure of reserve requirement compliance.
 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
any checks or other debit items drawn against them.
Calculating Reserve Requirement
 Classification of Reserve
 Primary Reserve with Central Bank or in vault
 Secondary Reserve in the form of near cash assets
 Working Reserve for daily operations
 Legal Reserve according to Central bank requirement
 Required Reserve
 Constituents and Functions of Primary Reserve (PR)
 Generally PR is related with central bank
 It has two forms: legal reserve and working reserve
 Constituents of PR: cash in hand, balance with the central bank and
demand deposits with other banks
 Functions:
 Protecting from any possible liquidity crisis
 First line of defense
 Satisfying the depositors’ claim instantaneously
 Performing the expected functions of the community
 Meeting the establishment expenses
Factors Influencing Legal Reserves
 Factors Influencing Working Reserves
Internal Factors:
 Level of bank operation
 Deposits Mix
 Size of secondary reserve

External Factors

Local Factors: Location, habits of the clients, business condition, seasonal

influence, existence of other banks, volume of the working reserves etc.

National Factors: Cost of fund, condition of the national economy etc.

 Constituents and Functions of Secondary Reserve (SR)
 SR aims at avoiding unexpected liquidity crisis
 The constituents are marketable near cash financial assets.
 An assets should meet three basic conditions to be included into those
financial assets. (convertibility, low risk and yield)
Functions of SR:
 Avoiding liquidity crisis
 Earning a moderate income
 Establishing a trade-off between liquidity and profitability
 Primary Reserve vs. Secondary Reserve
 Objective: Liquidity only vs liquidity plus some yield
 Forms: Only in cash vs financial securities
 Location: (Vault, Central bank and current depsoits in sister banks) vs
(with issuers and dealers)
 Extent of Liquidity: 100% vs less than 100%
 Rate of Yield: Nothing and some yield
 Types: (Legal and working) vs no classification
 Quantity: Smaller vs larger
 Defense: First line vs second line
 Level of Risk: zero vs insignificant risk involved
 Legal Reserves in Bangladesh
 The reserve requirement (or cash reserve ratio) is a central bank regulation
that sets the minimum reserves each commercial bank must hold (rather
than lend out) of customer deposits and notes.
 It is normally in the form of cash stored physically in a bank vault (vault
cash) or deposits made with a central bank.

Conventional Bank:
 The present statutory liquidity reserve (SLR) requirement is 13% of total
demand and time liabilities.
 5% (daily) 5.5 (bi weekly) of which is to be maintained as cash reserve
ratio (CRR)

For Islamic Bank:

 The SLR requirement for Islamic banks is 5.5%
 5% (daily) 5.5 (bi weekly) of which is to be maintained as cash reserve
ratio (CRR), and
 Daily Statement of Statutory Reserve
 According to section 33(1) of Banking Company’s Act, 1991; scheduled
banks must maintain SLR.
 There is a specific form used by the Bangladesh Bank for the record of this
reserve account.

Name of the Bank:

Month:

Daily Statement of Statutory Reserve Items

Balance of Current Value not more than current

Balance of Current Account held by the market price
Balance of Reserve in Account held by the concerned bank with TT in
Date Total Comment
the concerned Bank concerned bank with Sonali Bank as the Transits
Bangladesh Bank agent of the Unimpeachable
Bangladesh Bank Gold Approved
Securities
Factors in Choosing among the Different Sources of Reserves
 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
 Outlook for central bank monetary policy
 Rules and regulations applicable to a liquidity source
 Exercises
 The Double Trouble State Bank has incoming deposits of $2000,
revenues from non-deposit 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? Ans: $1500 Surplus

 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? Ans: $81 million
Question
&
Answer
44