Chapter Eleven

Liquidity and Reserve

Management: Strategies and
Policies

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Liquidity

The Availability of Cash in the Amount

and at the Time Needed at a
Reasonable Cost

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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
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Demands for Liquidity

Customer Deposit Withdrawals
Credit Requests from Quality Loan
Customers
Repayment of Nondeposit Borrowings
Operating Expenses and Taxes
Payment of Stockholder Dividends
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A Financial Firms Net

Liquidity Position

L =

Supplies of Liquid Funds

- Demands for Liquidity

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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

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Essence of Liquidity
Management
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
Firms Expected Profitability.

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Why Banks and Their

Competitors Face Significant
Liquidity Problems
Imbalances Between Maturity Dates of
Their Assets and Liabilities
High Proportion of Liabilities Subject to
Immediate Repayment
Sensitivity to Changes in Interest Rates
Central Role in the Payment Process
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Strategies for Liquidity

Managers
Asset Liquidity Management or
Asset Conversion Strategy
Borrowed Liquidity or Liability
Management Strategy
Balanced Liquidity Strategy
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Asset Liquidity
Management
This Strategy Calls for Storing
Liquidity in the Form of Liquid
Assets and Selling Them When
Liquidity is Needed

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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
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Options for Storing Liquidity

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

Management
Loss of Future Earnings on Assets That
Must Be Sold
Transaction Costs 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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Borrowed Liquidity
Management
This Strategy Calls for the Bank
to Purchase or Borrow from the
Money Market To Cover All of Its
Liquidity Needs

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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
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Balanced Liquidity
Management Strategy
The Combined Use of Liquid
Asset Holdings (Asset
Management) and Borrowed
Liquidity (Liability Management)
to Meet Liquidity Needs
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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
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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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Sources and Uses of Funds

Loans and Deposits Must Be Forecast 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
Banks Net Liquid Funds By Comparing the
Estimated Change in Loans to the
Estimated Change in Deposits
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Structure of Funds
A Banks Deposits and Other Sources of
Funds Divided Into Categories. For
Example:
Hot Money Liabilities
Vulnerable Funds
Stable Funds

Liquidity Manager Set Aside Liquid

Funds According to Some Operating Rule
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Liquidity Indicator Approach

Cash Position
Indicator
Liquid Security
Indicator
Net Federal Funds
Position
Capacity Ratio
Pledged Securities
Ratio
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Hot Money Ratio

Deposit Brokerage
Index
Core Deposit Ratio
Deposit Composition
Ratio
Loan Commitment
Ratio
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Market Signals of Liquidity

Management
Public Confidence
Stock Price Behavior
Risk Premiums on CDs
Loss Sales of Assets
Meeting Commitments to Creditors
Borrowings from the Central Bank
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