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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
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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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 monitor as well what is
happening to its cost of funds. One indicator
of the adequacy of the liquidity position is its
cost - a rising interest cost may reflect greater
perceived risk for the borrowing bank as
viewed by capital-market investors.
11-9
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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
Municipal Bonds and
Notes
Federal Agency
Securities
Negotiable
Certificates of
Deposits

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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
Liquidity managers should know what other
departments within the institution are doing
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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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Liquidity management using
sources and uses of funds
Suppose that a bank estimates its total
deposits for the next six months in
millions of dollars will be, respectively
$112, $132, $121, $147, $151 and $139,
while its loans (also in millions of dollars
will total as estimated $87, $95, $201, $113,
$101 and $124, respectively, over the same
six months. Under the sources and uses of
funds approach, when does this bank face
liquidity deficits, if any?
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Sources and Uses of Funds
approach
Deposits Loans depo loans Deficit/
surplus
112 87 D - L
132 95 20 8 12
121 102 -11 7 -18
147 113 26 11 15
151 101 4 -12 16
139 124 -12 23 -35
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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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Structure of funds
Suppose that a thrift institutions liquidity division
estimates that it holds $19 million in hot money
deposits and other IOUs against which it will hold an
80 percent liquidity reserve, $54 million in vulnerable
funds against which it plans to hold a 25 percent
reserve, and $112 million in stable or core funds against
which it will hold a 5 percent liquidity reserve. The
thrift expects its loans to grow 8 percent annually; its
loans currently stand at $117 million, but have recently
reached $132 million. If reserve requirements on
liabilities currently stand at 3 percent, what is this
depository institutions total liquidity requirement?
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Structure of funds
Total Liquidity Requirement
= 0.80 ($19 million - 0.03 x $19 million) + 0.25
($54 million - 0.03 x $54 million) + 0.05 ($112
million - 0.03 x $112 million) + ($132 million
+0.08 x $132 million - $117 million)
= $58.83 million
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Steps needed for the structure of
funds approach
In the first step, the institution's deposits and
other funds sources are divided into categories
based on their estimated probability of being
withdrawn and, therefore, lost to the bank.
Second, the liquidity manager must set aside
liquid funds according to some desired
operating rules for those categories. Categories
can include "hot money" liabilities, vulnerable
funds, and stable funds.
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Problem on liquidity requirement
Suppose Abigail Savings Bank's liquidity
manager estimates that the bank will experience
a $430 million liquidity deficit next month with a
probability of 10 percent, a $300 million liquidity
deficit with a probability of 40 percent, a $230
million liquidity surplus with a probability of 30
percent, and a $425 million liquidity surplus
bearing a probability of 20 percent. What is this
savings banks expected liquidity requirement?
What should management do?
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Liquidity requirement answer
The bank's expected liquidity requirement is:
Expected Liquidity Requirement = 0.10 *(-$430
million) + 0.40 * (-$300 million) + 0.30*
($230 million) + 0.20 * (+$425 million)
= -$43 million - $120 million + $69 million +
$85 million
= -$9 million
11-28
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The liquidity indicator approach to
liquidity management?
The liquidity indicator approach uses tell-
tale financial ratios (e.g., total loans/total
assets or cash assets/total assets) whose
changes over time may reflect the
changing liquidity position of the financial
institution. The ratios are used to estimate
liquidity needs and to monitor changes in
the liquidity position.
11-29
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Liquidity Indicator Approach
Cash Position Indicator
Liquid Security
Indicator
Net Federal Funds
Position
Capacity Ratio
Pledged Securities
Ratio
Hot Money Ratio
Deposit Brokerage
Index
Core Deposit Ratio
Deposit Composition
Ratio
Loan Commitment
Ratio

11-30
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Liquidity indicator approach
First National Bank has the following
balance sheet cash = 633, Govt. sec= 185,
net loans = 3502, fed funds sold = 48. Fed
funds purchased = 62, DD= 988, time
deposits =2627. How many liquidity
indicators can be calculated from these
figs.
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Liquidity indicator answers
The liquidity indicators that we can construct
from the foregoing figures include:
Cash Position Indicator:
Cash and Deposits Due from Other Banks
$633/Total Assets $4496 = 14.08%
Net Federal Funds Position:
(Federal Funds Sold Federal Funds
Purchases)=($48 - $62)/Total Assets $4496= -
.31%
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Liquidity indicators answers
Capacity Ratio:
Net Loans and Leases $3,502/Total Assets
$4496 = 77.89 percent
Deposit Composition Ratio:
Demand Deposits $988/Time deposits
$2,627 =37.61 percent
Liquid Securities Indicator:
U.S. Government Securities $185/total
assets $4496=4.11 percent

11-33
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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
No financial institution can tell for sure if
it has sufficient liquidity until it has
passed the market's test.
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What is money position
management?
A money position manager is responsible
for ensuring that the institution maintains
an adequate level of legal reserves.
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Legal Reserves


Assets That a Central Bank Requires
Depository Institutions to Hold as a
Reserve Behind Their Deposits or
Other Liabilities
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What is the principal goal of money
position management?
The money-position manager wants to
insure the bank has sufficient legal
reserves to meet its reserve requirements
as imposed by the central bank but holds
no more than the legal minimum
requirement because excess legal reserves
yield no income for the bank.
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How is the legal reserve
requirement determined?
Each reservable liability item is multiplied by the
stipulated reserve requirement percentage set by the
Federal Reserve Board to derive the bank's total legal
reserve requirements.
Thus, total required legal reserves equal the reserve
requirement on transaction deposits times the daily
average amount of net transaction deposits over a
designated period plus the reserve requirement on
nontransaction reservable liabilities times the daily
average amount of nontransaction reservable liabilities.
Currently nontransaction liabilities have a reserve
requirement of zero.
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U.S. Legal Reserve Requirements
First $7.8 Million have 0 Legal Reserves
3 Percent of End-of-the-Day Daily Average for a
Two Week Period For Transaction Accounts Up
To $48.3 Million
10 Percent of End-of-the-Day Daily Average for
a Two Week Period For Transaction Accounts
For Amounts Over $48.3 Million
Transaction Accounts Include Checking
Accounts, NOW Accounts and Other Deposits
Used to Make Payments
The $48.3 Million Amount is Adjusted Annually
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Required reserves
First National Bank finds that its net
transactions deposits average $140 million
over the latest reserve computation
period. Given the reserve requirement
ratios imposed by the Federal Reserve as
given in the textbook, what is the bank's
total required legal reserve?
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Reserve requirement answer
Reserve Requirement = 0.03 * [First $48.3 -
$7.8 million of Transaction Deposits] +
.10*[Amount of Transaction Deposits in
Excess of $48.3 million]
= .03 * $40.5 + .10 * ($140 - $48.3)
= $1.215 million + $9.17 million
= $10.385 million
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Reserve requirement
A U.S. savings bank has a daily average reserve
balance at the Federal Reserve Bank in its district
of $25 million during the latest reserve
maintenance period. Its vault cash holdings
have averaged $1 million and the bank's total
transaction deposits (net of interbank deposits
and cash items in collection) averaged $200
million daily over the latest reserve maintenance
period. Does this depository institution have a
legal reserve deficiency? How would you
recommend that its management responds to the
current situation?
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Reserve requirements - answer
The bank's total required legal reserves must be:
Required Legal Reserves = 0.03 x [First $48.3 $7.8 million
of Transactions Deposits] + 0.10 x [Transactions Deposits
Over $48.3 million]
= $1.215 million + $15.17 million
= $16.385 million
The average vault cash of $1 million plus the $25
million at the district Reserve Bank indicates total
maintained reserves of $26 million, meaning the bank is
over required reserves by $9,615,000. Management will
have to plan how to invest this excess reserve taking
into account any anticipated drain on funds in the near
future and taking into account any reserve deficit in the
previous period.
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Factors to consider in meeting a
deficit in legal reserve account?
Several factors must be taken into account by the
liquidity manager, including current and
expected future levels of interest rates, projected
changes in monetary policy, the bank's
borrowing capacity and current holdings of
liquid assets, the bank's forecast of future
deposit growth and loan demand, the expected
size and duration of any liquidity deficits or
surpluses, and his or her knowledge of the
future plans of the bank's largest depositors and
borrowers with credit lines.
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Reserve Maintenance Period


The Period of Time Over Which a
Bank Must Hold the Required
Amount of Legal Reserves that the
Law Demands
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Reserve Computation Period


The Period of Time Over Which a
Bank Calculates its Legal Reserve
Requirement
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Factors in Choosing Among
Different Sources of Reserves
Immediacy of Banks Needs
Duration of Banks Needs
Banks 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
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What are clearing balances?
Of what benefit can clearing balances be to a
depository that uses the Federal Reserve Systems
check-clearing network?
Any financial institution using the Federal Reserve
check clearing system has to maintain a minimum
balance with the Federal Reserve. The amount 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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Clearing balances
Suppose a bank maintains an average clearing
balance of $5 million during a period in which
the Federal funds rate averages 6 percent. How
much would this bank have available in credits
at the Federal Reserve Bank in its district to help
offset the charges assessed against the bank for
using Federal Reserve services?
Reserve Credit = Avg. Clearing Balance x
Annualized Fed Funds Rate x 14 days/360 days
= $5,000,000 x .06 x 14/360 = $11,666.67

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Sweep Account
A Contractual Account Between Bank
and Customer that Permits the Bank
to Move Funds Out of a Customers
Checking Account Overnight in
Order to Generate Higher Returns for
the Customer and Lower Reserve
Requirements for the Bank
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Customer Relationship Doctrine


Management Should Strive to Meet
All Good Loans that Walk in the Door
in Order to Build Lasting Customer
Relationships