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ChapterElevenLiquidityandReservesManagement:StrategiesandPolicies
KeyTopicsSourcesofDemandforandSupplyofLiquidityWhyFinancialFirmsHaveLiquidityProblemsLiquidityManagementStrategiesEstimatingLiquidityNeedsTheImpactofMarketDisciplineLegalReservesandMoneyManagement
IntroductionOneofthemostimportanttasksthemanagementofanyfinancialinstitutionfacesisensuringadequateliquidityatalltimesAfinancialfirmisconsideredtobe“liquid”ifithasreadyaccesstoimmediatelyspendablefundsatreasonablecostatpreciselythetimethosefundsareneededThissuggeststhataliquidfinancialfirmeitherhasTherightamountofimmediatelyspendablefundsonhandwhentheyarerequiredTheycanraiseliquidfundsintimelyfashionbyborrowingorsellingassetsLackofadequateliquiditycanbeoneofthefirstsignsthatafinancialinstitutionisintroubleAfinancialfirmcanbeclosedifitcannotraisesufficientliquidityeventhough,technically,itmaystillbesolvent
TheDemandforandSupplyofLiquidityDemandsforLiquidityCustomerdepositwithdrawalsCreditrequestsfromqualityloancustomersRepaymentofnondepositborrowingsOperatingexpensesandtaxesPaymentofstockholderdividendsSuppliesofLiquidFundsIncomingcustomerdepositsRevenuesfromthesaleofnondepositservicesCustomerloanrepaymentsSalesofbankassetsBorrowingsfromthemoneymarket
TheDemandforandSupplyofLiquidity(continued)Thesevarioussourcesofliquiditydemandandsupplycometogethertodetermineeachfinancialfirm’snetliquiditypositionatanymomentintimeThatnetliquidityposition(L)attimetisLiquidityDeficitisLt<0andLiquiditySurplusisLt>0
TheDemandforandSupplyofLiquidity(continued)TheessenceofliquiditymanagementproblemsforfinancialinstitutionsRarelyaredemandsforliquidityequaltothesupplyofliquidityatanyparticularmomentintimeThefinancialfirmmustcontinuallydealwitheitheraliquiditydeficitoraliquiditysurplus.Thereisatrade-offbetweenliquidityandprofitabilityThemoreresourcesaretiedupinreadinesstomeetdemandsforliquidity,theloweristhatfinancialfirm’sexpectedprofitability(otherfactorsheldconstant)
WhyFinancialFirmsOftenFaceSignificantLiquidityProblemsImbalancesbetweenmaturitydatesoftheirassetsandliabilitiesHighproportionofliabilities(especiallydemanddepositsandmoneymarketborrowings)aresubjecttoimmediaterepaymentSensitivitytochangesininterestratesMayaffectcustomerdemandfordepositsMayaffectcustomerdemandforloansCentralroleinthepaymentprocess,reputationandpublicconfidenceinthesystem
StrategiesforLiquidityManagersThinkaboutwhatisaliquidasset?Liquidassetshaveareadymarket,stablepriceandarereversibleIdentifystrategiesforliquiditymanagementAssetLiquidityManagementorAssetConversionStrategyThisstrategycallsforstoringliquidityintheformofliquidassets(T-bills,fedfundsloans,CDs,etc.)andsellingthemwhenliquidityisneededBorrowedLiquidityorLiabilityManagementStrategyThisstrategycallsforthebanktopurchaseorborrowfromthemoneymarkettocoverallofitsliquidityneedsBalancedLiquidityStrategyThecombineduseofliquidassetholdings(AssetManagement)andborrowedliquidity(LiabilityManagement)tomeetliquidityneeds
StrategiesforLiquidityManagers(continued)GuidelinesforLiquidityManagersKeeptrackofallfund-usingandfund-raisingdepartmentsKnowinadvancewithdrawalsbythebiggestcreditordepositcustomersPrioritiesandobjectivesforliquiditymanagementshouldbeclearLiquidityneedsmustbeevaluatedonacontinuingbasis
EstimatingLiquidityNeedsSourcesandUsesofFundsApproachStructureofFundsApproachLiquidityIndicatorApproachTheUltimateStandardforAssessingLiquidityNeeds:SignalsfromtheMarketplace
EstimatingLiquidityNeeds(continued)SourcesandUsesofFundsApproachLoansanddepositsmustbeforecastforagivenliquidityplanningperiodTheestimatedchangeinloansanddepositsmustbecalculatedforthesameplanningperiodTheliquiditymanagermustestimatethebank’snetliquidfundsbycomparingtheestimatedchangeinloanstotheestimatedchangeindeposits
EstimatingLiquidityNeeds(continued)SourcesandUsesofFundsApproach
EstimatingLiquidityNeeds(continued)SourcesandUsesofFundsApproach
EstimatingLiquidityNeeds(continued)SourcesandUsesofFundsApproach
EstimatingLiquidityNeeds(continued)StructureofFundsApproachABank’sDepositsandOtherSourcesofFundsDividedIntoCategories.ForExample:‘HotMoney’Liabilities(volatileliabilities)VulnerableFundsStableFunds(coredepositsorcoreliabilities)LiquidityManagerSetAsideLiquidFundsAccordingtoSomeOperatingRule
EstimatingLiquidityNeeds(continued)StructureofFundsApproachForexample,themanagermaydecidetosetupA95percentliquidreservebehindallhotmoneyfunds(lessanyrequiredlegalreservesheldbehindhotmoneydeposits)30percentinliquidreservesforvulnerabledepositandnondepositliabilities15percentorlessinliquidreservesforstable(core)fundssources
EstimatingLiquidityNeeds(continued)StructureofFundsApproachCombiningbothloananddepositliquidityrequirements,thisinstitution’stotalliquidityrequirementwouldbe
EstimatingLiquidityNeeds(continued)StructureofFundsApproachManyfinancialfirmsliketocalculatetheirexpectedliquidityrequirement,basedontheprobabilitiestheyassigntodifferentpossibleoutcomes
EstimatingLiquidityNeeds(continued)LiquidityIndicatorApproachCashpositionindicatorLiquidsecuritiesindicatorNetfederalfundsandrepurchaseagreementspositionCapacityratioPledgedsecuritiesratioHotmoneyratioDepositbrokerageindexCoredepositratioDepositcompositionratioLoancommitmentsratio
EstimatingLiquidityNeeds(continued)TheUltimateStandardforAssessingLiquidityNeeds:SignalsfromtheMarketplaceLiquiditymanagersshouldcloselymonitorthefollowingmarketsignals:PublicconfidenceStockpricebehaviorRiskpremiumsonCDsandotherborrowingsLosssalesofassetsMeetingcommitmentstocreditcustomersBorrowingsfromthecentralbank
LegalReservesandMoneyPositionManagementLegalReservesThoseassetsthatlawandcentralbankregulationsaymustbeheldduringaparticulartimeperiodThecurrentsystemofaccountingforlegalreservesiscalledlaggedreserveaccounting(LRA)Thedailyaverageamountofdepositsandotherreservableliabilitiesarecomputedusinginformationgatheredoveratwo-weekperiodstretchingfromaTuesdaythroughaMondaytwoweekslaterThisintervaloftimeisknownasthereservecomputationperiodThedailyaverageamountofvaultcasheachdepositoryinstitutionholdsisalsofiguredoverthesametwo-weekcomputationperiod
EXHIBIT11–1FederalReserveRulesforCalculatingaWeeklyReportingDepositoryInstitution’sRequiredLegalReserves
LegalReservesandMoneyPositionManagement(continued)LegalReservesOnlytwokindsofassetscanbeusedforthispurposeCashinthevaultDepositsheldinareserveaccountwiththeregionalFedThereserverequirementin2010was3percentoftheend-of-the-daydailyaverageamountheldoveratwo-weekperiod,from$10.7millionupto$58.8millionThefirst$10.7millionhavezerolegalreservesThe$58.8millionfigureisknownasthereservetrancheandchangeseveryyearbasedondepositgrowthTransactiondepositsover$58.8millionheldbythesamedepositoryinstitutioncarrieda10percentlegalreserverequirementThisannuallegalreserveadjustmentisdesignedtooffsetinflation
LegalReservesandMoneyPositionManagement(continued)CalculatingRequiredReservesThelargestdepositoryinstitutionsmustholdthelargestpercentageoflegalreservesEachreservableliabilityitemismultipliedbythestipulatedreserverequirementpercentagetoderiveeachdepository’stotallegalreserverequirement
LegalReservesandMoneyPositionManagement(continued)CalculatingRequiredReservesThelargestdepositoryinstitutionsmustholdthelargestpercentageoflegalreservesEachreservableliabilityitemismultipliedbythestipulatedreserverequirementpercentagetoderiveeachdepository’stotallegalreserverequirement
LegalReservesandMoneyPositionManagement(continued)ClearingBalancesInadditiontoholdingalegalreserveaccountatthecentralbank,manydepositoryinstitutionsalsoholdaclearingbalancewiththeFedtocoveranychecksorotherdebititemsdrawnagainstthemForexample,supposeabankhadaclearingbalanceaveraging$1millionduringaparticulartwo-weekmaintenanceperiodandtheFederalfundsinterestrateoverthissameperiodaveraged5.50percentThenitwouldearnaFederalReservecreditofAssuminga360-dayyearforeaseofcomputation,thisbankcouldapplyupto$2,138.89tooffsetanyfeeschargedtothebankforitsuseofFederalReserveservices
LegalReservesandMoneyPositionManagement(continued)FactorsInfluencingtheMoneyPosition
LegalReservesandMoneyPositionManagement(continued)SweepAccountsVolumeoflegalreservesheldattheFedhasdeclinedinrecentyearslargelyduetosweepaccountsAcontractualaccountbetweenabankandacustomerthatpermitsthebanktomovefundsoutofacustomer’scheckingaccountovernightinordertogeneratehigherreturnsforthecustomerandlowerreserverequirementsforthebankRetailSweepBusinessSweepThesweepsmarketislikelytochangeinformandimportanceduetotherecentpassageoftheDodd-FrankWallStreetReformandConsumerProtectionActof2009
LegalReservesandMoneyPositionManagement(continued)OtherFactorstoInfluenceLegalReservesUseofFedFundsMarketThecheapestsourceButveryvolatileManagersrelyontheFedfundstargetrate(themostvolatileonthesettlementdate)OtherOptionsSellliquidsecuritiesDrawuponexcesscorrespondentbalancesEnterintorepurchaseagreementsfortemporaryborrowingsSellnewtimedepositsBorrowintheEurocurrencymarket
EXHIBIT11–2MovementsintheEffectiveFederalFundsRate,ItsTarget(theIntendedFederalFunds)Rate,andtheDiscount(PrimaryCredit)RateforDepositoryInstitutionsSeekingCreditfromtheFederalReserveBanks
FactorsinChoosingamongtheDifferentSourcesofReservesInchoosingwhichsourceofreservestodrawupontocoveralegalreservedeficit,managersmustcarefullyconsiderseveralaspectsoftheirinstitution’sneedforliquidfunds:ImmediacyofneedDurationofneedAccesstothemarketforliquidfundsRelativecostsandrisksofalternativesourcesoffundsTheinterestrateoutlookOutlookforcentralbankmonetarypolicyRulesandregulationsapplicabletoaliquiditysource
CentralBankReserveRequirementsaroundtheGlobeNotallcentralbanksimposelegalreserverequirementsonthedepositoryinstitutionstheyregulateForexample,theBankofEnglandhasnotestablishedofficialreserverequirementsforitsbanksThereisatrendamongcentralbanksaroundtheglobetoeliminate,suspend,oratleastmakelessuseofthereserverequirementtool,inpartbecauseitissodifficulttocontrolAnotableexceptionistheEuropeanCentralBank(ECB)Evenifcentralbanksimposednoreserverequirements,managersofdepositoryinstitutionswouldstillhaveademandforcashreservesAlldepositoryinstitutionsatonetimeoranotherneedimmediatelyavailablefundstohandlecustomerwithdrawals,meetnewloandemand,andsatisfyotheremergencycashneeds
QuickQuizWhataretheprincipalsourcesofliquiditydemandforafinancialfirm?Whataretheprincipalsourcesfromwhichthesupplyofliquiditycomes?Whydofinancialfirmsfacesignificantliquiditymanagementproblems?Whataretheprincipaldifferencesamongassetliquiditymanagement,liabilitymanagement,andbalancedliquiditymanagement?Howdoesthesourcesandusesoffundsapproachhelpamanagerestimateafinancialinstitution’sneedforliquidity?Howcanthedisciplineofthemarketplacebeusedasaguideformakingliquiditymanagementdecisions?Whataresweepaccounts?WhyhavetheyledtoasignificantdeclineinthetotallegalreservesheldattheFederalReservebanksbydepositoryinstitutionsoperatingintheUnitedStates?Whatimpacthasrecentfinancialreformlegislationhadonraisingshort-termcash?