Chapter Eleven

Liquidity and Reserves Management:

Strategies and Policies
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
 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 bank’s
cash balance and liquidity position: Deposits
and withdrawals; loan disbursements and
loan payments
 11-3

Supplies of Liquid Funds

• Incoming Customer Deposits

• Revenues from the Sale of Nondeposit

Services

• Customer Loan Repayments

• Sales of Bank Assets

• Borrowings from the Money Market

 11-4

Demands for Liquidity

• Customer Deposit Withdrawals

• Credit Requests from Quality Loan

Customers

• Repayment of Nondeposit Borrowings

• Operating Expenses and Taxes

• Payment of Stockholder Dividends

11-5
 11-6

A Financial Firm’s Net Liquidity

Position

L = Supplies of Liquid Funds

- Demands for Liquidity
 11-7

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) Nondeposit 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.
What is this bank’s projected net liquidity position for the coming
week?
 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 Firm’s Expected
Profitability.
 11-9

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
▫ May affect customer demand for loans

• Central Role in the Payment Process, Reputation and

Public Confidence in the System
 11-10

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

 11-11

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
 11-12

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
 11-13

Options for Storing Liquidity

• Treasury Bills • Municipal Bonds and
• Fed Funds Sold to Notes
Other Banks • Federal Agency
• Purchasing Securities Securities
for Resale (Repos) • Negotiable Certificates
• Deposits with of Deposits
Correspondent Banks • Eurocurrency Loans
 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
 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
 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
 11-17

Borrowed Liquidity (Liability)

Management Strategy
Advantages Disadvantages

• Borrow Only When There • Highest Expected Return

is a Need for Funds But Carries the Highest
• Volume and Composition Risk Due to Volatility of
of the Investment Interest Rates and Possible
Portfolio Can Remain Rapid Changes in Credit
Unchanged 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
of funds) Financial Difficulties
 11-18

Balanced Liquidity Management

Strategy

The Combined Use of Liquid Asset

Holdings (Asset Management) and
Borrowed Liquidity (Liability
Management) to Meet Liquidity
Needs
 11-19

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
 11-20

Customer Relationship Doctrine

Management Should Strive to Meet All

Good Loans that Walk in the Door in
Order to Build Lasting Customer
Relationships