Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

CHAPTER 11
LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES
Goal of his Chapter: he purpose of this chapter is to e!plore the reasons "hy financial
institutions often face heavy demands for immediately spenda#le funds $liquidity% and learn
a#out the methods they can use to prepare for meeting their cash needs&
'ey opics in his Chapter
Sources of (emand for and Supply of Liquidity
)hy *inancial *irms +ave Liquidity Pro#lems
Liquidity Management Strategies
,stimating Liquidity -eeds
he .mpact of Mar/et (iscipline
Legal Reserves and Money Management
Chapter 0utline
.& .ntroduction: Meaning of Liquidity
..& he (emand for and Supply of Liquidity
1& Sources of Liquidity (emands
2& Sources of Liquidity Supplies
C& -et Liquidity Position and Liquidity Surpluses and (eficits
...& )hy *inancial *irms 0ften *ace Significant Liquidity Pro#lems
1& Maturity Mismatches
2& Sensitivity to Changes in Mar/et .nterest Rates
C& Meeting (emand for Liquidity and Pu#lic Confidence
.3& Strategies for Liquidity Managers
1& 1sset Liquidity Management $or 1sset Conversion% Strategies
2& 2orro"ed Liquidity $Lia#ility% Management Strategies
C& 2alanced Liquidity Management Strategies
(& Guidelines for Liquidity Managers
3& ,stimating Liquidity -eeds
1& he Sources and 4ses of *unds 1pproach
2& he Structure of *unds 1pproach
C& Liquidity .ndicator 1pproach
(& he 4ltimate Standard for 1ssessing Liquidity -eeds: Signals from the Mar/etplace
1& Pu#lic confidence
5& Stoc/ price #ehavior
6& Ris/ premiums on C(s and other #orro"ings
7& Loss sales of assets
8& Meeting commitments to credit customers
9& 2orro"ings from the central #an/
11-1
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
3.& Legal Reserves and Money Position Management
1& he Money Position Manager
2& Legal Reserves
C& Regulations on Calculating Legal Reserve Requirements
1& Reserve Computation
5& Reserve Maintenance
6& Reserve Requirements
7& Calculating Required Reserves
8& Penalty for a Reserve (eficit
9& Clearing 2alances
(& *actors .nfluencing the Money Position
1& Controlla#le *actors
5& -oncontrolla#le *actors
6& 1n ,!ample
7& 4se of the *ederal *unds Mar/et
8& 0ther 0ptions #esides *ed *unds
9& 2an/ Si:e and 2orro"ing and Lending Reserves for the Money Position
;& 0verdraft Penalties
3..& *actors in Choosing among the (ifferent Sources of Reserves
1& .mmediacy of need
2& (uration of need
C& 1ccess to the mar/et for liquid funds
(& Relative costs and ris/s of alternative sources of funds
,& he interest rate outloo/
*& 0utloo/ for central #an/ monetary policy
G& Rules and regulations applica#le to a liquidity source
3...& Central 2an/ Reserve Requirements around the Glo#e
.<& Summary of the Chapter
Concept Chec/s
11-1& )hat are the principal sources of liquidity demand for a financial firm=
he most pressing demands for liquidity arise principally from customers "ithdra"ing money
from their deposits and from credit requests& +o"ever> demands for liquidity can also come
from paying off previous #orro"ings> operating e!penses and ta!es incurred during operations
and from payment of a cash dividend to stoc/holders&
11-5& )hat are the principal sources from "hich the supply of liquidity comes=
Supplies of funds stem principally from incoming deposits> sales of assets> particularly
mar/eta#le securities and repayments of outstanding loans& Liquidity also comes from the sale of
nondeposit services and #orro"ings from the money mar/et&
11-5
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-6& Suppose that a #an/ faces the follo"ing cash inflo"s and outflo"s during the coming
"ee/: $a% deposit "ithdra"als are e!pected to total ?66 million> $#% customer loan repayments
are e!pected to amount to ?1@A million> $c% operating e!penses demanding cash payment "ill
pro#a#ly approach ?81 million> $d% accepta#le ne" loan requests should reach ?5B7 million> $e%
sales of #an/ assets Concept Chec/ are proCected to #e ?1A million> $f% ne" deposits should total
?9;@ million> $g% #orro"ings from the money mar/et are e!pected to #e a#out ?76 million> $h%
nondeposit service fees should amount to ?5; million> $i% previous #an/ #orro"ings totaling ?56
million are scheduled to #e repaid> and $C% a dividend payment to #an/ stoc/holders of ?17@
million is scheduled& )hat is this #an/Ds proCected net liquidity position for the coming "ee/=
$.n millions of dollars%
Cash .nflo"s Cash 0utflo"s
Customer Loan Repayments ?1@A (eposit )ithdra"als ?66
Sales of 2an/ 1ssets 1A 0perating ,!penses 81
-e" (eposits 9;@ -e" Loan Requests 5B7
Money-Mar/et 2orro"ings 76 Repayment of Previous 2orro"ings 56
-ondeposit Service *ees 5; (ividend to Stoc/holders 17@
otal Cash .nflo"s ?A99 otal Cash 0utflo"s ?871
-et Liquidity
Position otal Cash otal Cash
ProCected for E .nflo"s - 0utflo"s
the Coming
)ee/
E ?A99 million - ?871 million
E F ?658 million
11-7& )hen is a financial institution adequately liquid=
1 financial institution is adequately liquid if it has adequate cash availa#le precisely "hen cash is
needed at a reasona#le cost& Management can monitor the cash position over time> and also
monitor "hat is happening to its cost of funds& 0ne indicator of the adequacy of the liquidity
position is its cost - a rising interest cost may reflect greater perceived ris/ for the #orro"ing
#an/ as vie"ed #y capital-mar/et investors&
11-8& )hy do financial firms face significant liquidity management pro#lems=
*inancial institutions are prone to liquidity management pro#lems due to:
11-6
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
$1% 1 maturity mismatch situation in "hich most depository institutions hold an unusually high
proportion of lia#ilities su#Cect to immediate payment> especially demand $chec/a#le% deposits
and money mar/et #orro"ingsG
$5% he sensitivity of changes to their assets and lia#ilities values to"ards mar/et interest-rate
movementsG and
$6% heir central role in the payments process&
11-9& )hat are the principal differences among asset liquidity management> lia#ility
management> and #alanced liquidity management=
1sset management is a strategy for meeting liquidity needs> used mainly #y smaller #an/s> in
"hich liquid funds are stored in readily mar/eta#le assets that can #e quic/ly converted into cash
as needed& Lia#ility management involves #orro"ing enough immediately spenda#le funds to
cover demands for liquidity made against a #an/& 2alanced liquidity management calls for using
#oth asset management and lia#ility management to cover a #an/Hs liquidity needs&
11-;& )hat guidelines should management /eep in mind "hen it manages a financial firmDs
liquidity position=
.t is important for a liquidity manager to: $a% /eep trac/ of the activities of other departments
"ithin the #an/G $#% /no" in advance the planned activities of the #an/Hs largest credit and
deposit customersG $c% set clear priorities and o#Cectives in liquidity managementG and $d% react
quic/ly to liquidity deficits and liquidity surpluses&
Liquidity managers must /no" "hat other departments "ithin the institution are doing #ecause
their activities affect the liquidity position and liquidity management decisions& he liquidity
manager can ma/e #etter decisions to profita#ly invest surplus liquid funds or avoid costly> last-
minute #orro"ings if he or she /no"s "hat the #an/Hs principal depositors and creditors "ill do
in advance& 2y setting clear priorities and o#Cectives the liquidity manager has a #etter chance to
ma/e sound decisions plus an a#ility to act quic/ly to invest surpluses in order to gain ma!imum
income or avoid costly deficits and prolonged #orro"ings&
11-A& +o" does the sources and uses of funds approach help a manager estimate a financial
institutionDs need for liquidity=
he sources and uses of funds approach estimates future deposit inflo"s and estimated outflo"s
of funds associated "ith e!pected loan demand and calculates the net difference #et"een these
items in each planning period&
11-7
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
)hen sources and uses of liquidity do not match> there is a liquidity gap> measured #y the si:e of
the difference #et"een sources and uses of funds& )hen sources of liquidity $e&g&> increasing
deposits or decreasing loans% e!ceed uses of liquidity $e&g&> decreasing deposits or increasing
loans% then the financial firm "ill have a positive liquidity gap $surplus%& .ts surplus liquid funds
must #e quic/ly invested in earning assets until they are needed to cover future cash needs& 0n
the other hand> "hen uses e!ceed sources> a financial institution faces a negative liquidity gap
$deficit%& .t no" must raise funds from the cheapest and most timely sources availa#le&
11-B& Suppose that a #an/ estimates its total deposits for the ne!t si! months in millions of
dollars to #e> respectively> ?115> ?165> ?151> ?17;> ?181 and ?16B> "hile its loans $also in
millions of dollars% "ill total an estimated ?A;> ?B8> ?1@5> ?116> ?1@1 and ?157> respectively>
over the same si! months& 4nder the sources and uses of funds approach> "hen does this #an/
face liquidity deficits> if any=
,stimated otal (eposits ,stimated otal Loans
?115 ?A;
165 B8
151 1@5
17; 116
181 1@1
16B 157
Change in (eposits Change in Loans
,stimated Liquidity
(eficit or Surplus
? --- ? --- ? ---
F5@ FA F15
-11 F; -1A
F59 F11 F18
F7 -15 F19
-15 F56 -68
Clearly> the #an/ has proCected liquidity surpluses $"hich should #e profita#ly invested% in three
out of si! months> #ut a deficit is estimated for the third and last month "hich "ill have to #e
covered through #orro"ings and possi#ly through the sale of liquid assets&
11-8
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-1@& )hat steps are needed to carry out the structure of funds approach to liquidity
management=
.n the first step> the institutionHs deposits and other funds sources are divided into categories
#ased upon their estimated pro#a#ility of #eing "ithdra"n and> therefore> lost to the financial
firm& Second> the liquidity manager must set aside liquid funds according to some desired
operating rules for those categories& Categories can include Ihot moneyI lia#ilities> vulnera#le
funds> and sta#le funds&
11-11& Suppose that a thrift institutionDs liquidity division estimates that it holds ?1B million in
hot money deposits and other .04s against "hich it "ill hold an A@ percent liquidity reserve>
?87 million in vulnera#le funds against "hich it plans to hold a 58 percent reserve> and ?115
million in sta#le or core funds against "hich it "ill hold a 8 percent liquidity reserve& he thrift
e!pects its loans to gro" A percent annuallyG its loans currently stand at ?11; million> #ut have
recently reached ?165 million& .f reserve requirements on lia#ilities currently stand at 6 percent>
"hat is this depository institutionDs total liquidity requirement=
otal Liquidity Requirement E @&A@ $?1B million - @&@6 ! ?1B million%
F @&58 $?87 million - @&@6 ! ?87 million%
F @&@8 $?115 million - @&@6 ! ?115 million%
F $?165 million F0&@A ! ?165 million - ?11; million%
E ?8A&A61 million
11-15& )hat is the liquidity indicator approach to liquidity management=
he liquidity indicator approach uses tell-tale financial ratios $e&g&> total loansJtotal assets or cash
assetsJtotal assets% "hose changes over time may reflect the changing liquidity position of the
financial institution& he ratios are used to estimate liquidity needs and to monitor changes in the
liquidity position&
11-16& *irst -ational 2an/ posts the follo"ing #alance sheet entries on todayDs date: -et loans
and leases> ?6>8@5 millionG cash and deposits held at other #an/s> ?966 millionG *ederal funds
sold ?7A millionG 4&S& government securities> ?1A8 millionG *ederal funds purchased> ?95
millionG demand deposits> ?BAA millionG time deposits> ?5>95; millionG and total assets> ?7>779
million& +o" many liquidity indicators can #e calculated from these figures=
11-9
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
$.n millions of dollars%
1ssets Lia#ilities
Cash (eposits held at *ederal *und Purchased ? 95
other 2an/s ? 966
4&S& Government securities ? 1A8 (emand (eposits ? BAA
-et Loans and Losses ?6>8@5 ime (eposits ?5>95;
*ederal *unds Sold ? 7A
otal 1ssets ?7>779
he liquidity indicators that "e can construct from the foregoing figures include:
Cash Position .ndicator:
Cash and (eposits (ue from 0ther 2an/s E ?966 E 17&57 percent
otal 1ssets ?7779
-et *ederal *unds Position:
$*ederal *unds Sold K *ederal *unds Purchased% E $?7A - ?95% E - @&61 percent
otal 1ssets ?7779
Capacity Ratio:
-et Loans and Leases E ?6>8@5 E ;;&;; percent
otal 1ssets ?7779
(eposit Composition Ratio:
(emand (eposits E ?BAA E 6;&91 percent
ime (eposits ?5>95;
Liquid Securities .ndicator:
4&S& Government Securities E ?1A8 E 7&19 percent
otal 1ssets ?7779
11-17& +o" can the discipline of the mar/etplace #e used as a guide for ma/ing liquidity
management decisions=
11-;
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
-o financial institution can tell for sure if it has sufficient liquidity until it has passed the
mar/etHs test& Specifically> management should loo/ at these signals: pu#lic confidence> stoc/
price #ehavior> ris/ premiums on C(s and other #orro"ings> loss sales of assets> meeting
commitments to credit customers and #orro"ings from the *ederal Reserve #an/s& .f pro#lems
e!ist in any of these areas> management needs to ta/e a close loo/ at its liquidity management
practices to determine "hether changes are in order&
11-18& )hat is money position management=
Money position management is the management of a financial institutionDs liquidity position that
requires quic/ decisions "hich may have long-run consequences on profita#ility& Most large
depository institutions have designated an officer of the firm as money position manager& 1
money position manager is responsi#le for ensuring that the institution maintains an adequate
level of legal reserves& Legal reserve requirements apply to all qualified depository institutions>
including commercial and savings #an/s> savings and loan associations> credit unions> and
agencies and #ranches of foreign #an/s that offer transaction deposits or nonpersonal $#usiness%
time deposits or #orro" through ,urocurrency lia#ilities&
11-19& )hat is the principal goal of money position management=
he money-position managementDs goal is to ensure that the #an/ has sufficient legal reserves to
meet its reserve requirements as imposed #y the central #an/& 1lso ma/e sure that it holds not
more than the minimum legal requirement #ecause e!cess legal reserves yield no income for the
#an/&
11-1;& ,!actly ho" is a depository institutionDs legal reserve requirement determined=
,ach reserva#le lia#ility item is multiplied #y the stipulated reserve requirement percentage set
#y the *ederal Reserve 2oard to derive the #an/Hs total legal reserve requirements& hus> 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 reserva#le lia#ilities times the daily average amount of nontransaction
reserva#le lia#ilities& Currently nontransaction lia#ilities have a reserve requirement of :ero&
11-A
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-1A& *irst -ational 2an/ finds that its net transactions deposits average ?17@ million over the
latest reserve computation period& 4sing the reserve requirement ratios imposed #y the *ederal
Reserve as given in the te!t#oo/> "hat is the #an/Hs total required legal reserve=
otal Required Legal Reserves E @&@6 L M*irst ?76&B-?B&6 million of ransaction (epositsN F
&1@LM1mount of ransaction (eposits in ,!cess of ?76&B millionN
E &@6 L ?67&9 F &1@ L $?17@ - ?76&B%
E ?1&@6A million F ?B&91 million
E ?1@&97A million
11-1B& 1 4&S& savings #an/ has a daily average reserve #alance at the *ederal Reserve #an/ in
its district of ?58 million during the latest reserve maintenance period& .ts vault cash holdings
averaged ?1 million and the savings #an/Hs total transaction deposits $net of inter#an/ deposits
and cash items in collection% averaged ?5@@ million daily over the latest reserve maintenance
period& (oes this depository institution have a legal reserve deficiency= +o" "ould you
recommend that its management responds to the current situation=
he #an/Hs total required legal reserves must #e:
Required Legal Reserves E @&@6 ! M*irst ?76&B K ?B&6 million of ransactions (epositsN F
@&1@ ! Mransactions (eposits 0ver ?76&B millionN
E &@6L?67&9 F &1@L$?5@@ - ?76&B%
E ?1&@6A million F ?18&91 million E ?19&97A million
he average vault cash of ?1 million plus the ?58 million at the district Reserve 2an/ indicates
total maintained reserves of ?59 million> meaning the #an/ is over required reserves #y
?B>685>@@@& Management "ill have to plan ho" to invest this e!cess reserve ta/ing into account
any anticipated drain on funds in the near future and ta/ing into account any reserve deficit in the
previous period&
11-5@& )hat factors should a money position manager consider in meeting a deficit in a
depository institutionDs legal reserve account=
Several factors must #e ta/en into account #y the money position manager> including current and
e!pected future levels of interest rates> proCected changes in monetary policy> the #an/Hs
#orro"ing capacity and current holdings of liquid assets> the #an/Hs forecast of future deposit
gro"th and loan demand> the e!pected si:e and duration of any liquidity deficits or surpluses>
and his or her /no"ledge of the future plans of the #an/Hs largest depositors and #orro"ers "ith
credit lines&
11-51& )hat are clearing #alances= 0f "hat #enefit can clearing #alances #e to a depository that
uses the *ederal Reserve SystemDs chec/-clearing net"or/=
11-B
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
1ny financial institution using the *ederal Reserve chec/ clearing system has to maintain a
minimum #alance "ith the *ederal Reserve& he amount is determined #y its estimated chec/
clearing needs and its recent record of overdrafts& he clearing #alance can #e a #enefit #ecause
the institution earns credits from holding this #alance "ith the *ed and this credit can #e used to
pay the fees the *ed charges for services&
11-55& Suppose a #an/ maintains an average clearing #alance of ?8 million during a period in
"hich the *ederal funds rate averages 9 percent& +o" much "ould this #an/ have availa#le in
credits at the *ederal Reserve 2an/ in its district to help offset the charges assessed against the
#an/ for using *ederal Reserve services=
Reserve Credit E 1vg& Clearing 2alance ! 1nnuali:ed *ed *unds Rate ! 17 daysJ69@ days
E ?8>@@@>@@@ ! &@9 ! 17J69@ E ?11>999&9;
11-56& )hat are s"eeps accounts= )hy have they led to a significant decline in the total legal
reserves held at the *ederal Reserve #an/s #y depository institutions operating in the 4nited
States=
1 s"eeps account is a service provided #y #an/s "here they s"eep money out of accounts that
carry reserve requirements $such as demand deposits and other chec/ing accounts% into savings
accounts "hich do not carry reserve requirements overnight& his service lo"ers the #an/Ds
overall cost of funds "hile still allo"ing the customer access to their deposits for payments&
hese s"eep arrangements account for nearly ?5@@ #illion in deposit #alances today and
therefore have significantly reduced the total reserve requirements of #an/s&
Pro#lems
11-1@
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-1& Pretty La/e +ills State 2an/ estimates that over the ne!t 57 hours the follo"ing cash
inflo" and outflo"s "ill occur $all figures in millions of dollars%:
(eposit "ithdra"als ?BA Sales of #an/ assets 7@
(eposit inflo"s A; Stoc/holder dividend payments 18@
Scheduled loan repayments AB
Revenues from sale of nondeposit
services B8
1ccepta#le loan requests 89 Repayments of #an/ #orro"ings 9@
2orro"ings from the money
mar/et ;8 0perating e!penses 78
)hat is this #an/Ds proCected net liquidity position in the ne!t 57 hours= *rom "hat sources can
the #an/ cover its liquidity needs=
(eposit "ithdra"als ?BA -
(eposit inflo"s ?A; F
Scheduled loan repayments ?AB F
1ccepta#le loan requests ?89 -
2orro"ings from the money mar/et ?;8 F
Sales of #an/ assets ?7@ F
Stoc/holder dividend payments ?18@ -
Revenues from sale of nondeposit
services ?B8 F
Repayment of #an/ #orro"ings ?9@ -
0perating e!penses ?78 -
E F M?A;F ?ABF ?;8F ?7@F ?B8N - M?BAF ?89F ?18@F ?9@F ?78N
E - ?56 million&
*aced "ith an e!pected liquidity deficit Pretty La/e +ills State 2an/ could arrange to increase
its money mar/et #orro"ings from other institutions or sell some of its assets or do some of #oth&
11-5& Mountain op Savings is proCecting a net liquidity deficit of ?8 million ne!t "ee/
partially as a result of e!pected quality loan demand of ?57 million> necessary repayments of
previous #orro"ings of ?18 million> dis#ursements to cover operating e!penses of ?1A million>
planned stoc/holder dividend payments of ?8 million> e!pected deposit inflo"s of ?59 million>
revenues from nondeposit service sales of ?1A million> scheduled repayment of previously made
customer loans of ?56 million> asset sales of ?1@ million> and money mar/et #orro"ings of ?18
million& +o" much must Mountain opDs e!pected deposit "ithdra"als #e for the coming "ee/=
11-11
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
Supplies of Liquidity *lo"ing into the Mountain op Savings
,!pected deposit inflo"s ?59 million
Revenues from nondeposit
service sales
1A million
Scheduled repayments of prev&
made customer loans 56 million
1sset sales 1@ million
Money mar/et #orro"ings 18 million
otal Source of Liquidity ?B5 million
(emands on the Mountain op Savings for
Liquidity
,!pected quality loan demand ?57 million
-ecessary repayments of
previous #orro"ings 18 million
(is#ursements to cover
operating e!penses 1A million
Stoc/holder dividend payments 8 million
otal 4ses of Liquidity ,!cluding
(eposit )ithdra"als ?95 million
hen -et Liquidity (eficit E Liquidity Supplies - Liquidity (emands - (eposit )ithdra"als
- ?8 million E ?B5 million - ?95 million - (eposit )ithdra"als
herefore> e!pected deposit "ithdra"als must equal ?68 million for the ne!t "ee/&
11-6& *irst -ational 2an/ of La"renceville has forecast its chec/a#le deposits> time and
savings deposits> and commercial and household loans over the ne!t eight months& he resulting
estimates $in millions% are sho"n in #elo"& 4se the sources and uses of funds approach to
indicate "hich months are li/ely to result in liquidity deficits and "hich in liquidity surpluses if
these forecasts turn out to #e true& ,!plain carefully "hat you "ould do to deal "ith each
monthDs proCected liquidity position&
11-15
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
Month
Chec/a#le
(eposits
ime and
Savings
(eposits
Commercial
Loans
Consumer
Loans
Oanuary 15@ 88@ 98@ 17@
*e#ruary 118 8@@ 98@ 5@@
March 1@@ 8@@ ;@@ 5@@
1pril B@ 7A8 ;@@ 18@
May 1@8 798 ;1@ 18@
Oune A@ 7B@ ;@@ 1;8
Ouly B@ 858 ;@@ 1;8
1ugust 1@@ 818 9;8 1;8
Solution:
Month
otal
(eposits
Change
from
Previous
Month
otal
Loans
Change
from
Previous
Month
Source 4se -et
Oanuary 9;@ ---- ;B@ ----
*e#ruary 918 -88 A8@ F9@ @ 118 -118
March 9@@ -18 B@@ F8@ @ 98 -98
1pril 8;8 -58 A8@ -8@ 8@ 58 F58
May 8;@ - 8 A9@ F1@ @ 1B -18
Oune 8;@ @ A;8 F18 @ 18 -18
Ouly 918 F78 A;8 @ 78 18 F78
1ugust 918 F @ A8@ -58 58 @ F58
Oanuary-*e#ruary> *e#ruary-March> 1pril-May and May-Oune "ill all have liquidity deficits as a
result of decreasing deposits> increasing assets> or #oth& March-1pril> Oune-Ouly> and Ouly-1ugust
"ill all have liquidity surpluses as a result of increasing deposits> decreasing loans> or #oth&
11-16
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
*irst -ational has several options availa#le:
Oanuary-*e#ruary> *e#ruary-March> 1pril-May and May-Oune the #an/ faces deficits ranging
from ?18 to ?118 million& hese deficits can #e met #y:
1& aggressive advertising to attract -0) deposits>
5& issuing negotia#le C(s in the money mar/et>
6& if they have a holding company> the holding company could sell commercial paper and
pass the proceeds through to the #an/ su#sidiary>
7& #orro"ing *ederal funds>
8& #orro"ing from the *ederal Reserve district #an/ $although this is not a li/ely alternative
for most #an/s%>
9& selling securities under agreements to repurchase>
;& selling some of their loans>
A& selling some of their securities> or
B& a com#ination of a num#er of these alternatives&
March-1pril> Oune-Ouly> and Ouly-1ugust the #an/ faces anticipated surpluses ranging from ?58
to ?78 million& hese surpluses afford the #an/ the opportunity to:
1& aggressively pursue ne" loans>
5& invest in various money mar/et instruments> such as reasury securities> or>
6& a com#ination of these alternatives&
Since #oth periods are relatively short lived> the #an/ should opt for more temporary measures>
that is> use of the money mar/et& +o"ever> if their longer-term forecasts hold promise for
continued gro"th> they may "ell "ant to develop strategies for attracting more deposits and
loans> as "ell&
11-7& 'ing Savings is attempting to determine its liquidity requirements today $the last day of
1ugust% for the month of Septem#er& Septem#er is usually a month of heavy loan demand due to
the #eginning of the school term and the #uildup of #usiness inventories of goods and services
for the fall season and "inter& his thrift institution has analy:ed its deposit accounts thoroughly
and classified them as e!plained #elo"&
Management has elected to hold a ;8 percent reserve in liquid assets or #orro"ing
capacity for each dollar of hot money deposits> a 5@ percent reserve #ehind vulnera#le deposits
and a 8 percent reserve for its holdings of core funds& 1ssume time and savings deposits carry a
:ero percent reserve requirement and all chec/a#le deposits carry a 6 percent reserve
requirement& 'ing currently has total loans outstanding of ?5>6AB million> "hich t"o "ee/s ago
"ere as high as ?5>89; million& .ts loansD mean annual gro"th over the past three years has #een
a#out A percent& Carefully prepare lo" and high estimates for 'ingDs total liquidity requirement
for Septem#er&
11-17
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
Millions of
(ollars
Chec/a#le
(eposits Savings (eposits
ime
(eposits
+ot money funds ?1@ ?PPPP ?;A5
3ulnera#le funds 55 185 87@
Sta#le $core%
funds 6@ 5A8 1;5
Source
Chec/a#le
deposits
Savings
deposits
-onpersonal
time deposits otals
+ot money funds ?1@ ---- ;A5 ;B5
3ulnera#le funds 55 185 87@ ;17
Sta#le $core% funds ?6@ 5A8 1;5 7A;
otals 95 76; 1>7B7 1>BB6
(eposit Liquidity Requirement E @&;8 M-et I+ot MoneyI *undsN F @&5@ M-et 3ulnera#le *undsN
F @&@8 M-et ICoreI *undsN
a% -et +ot Money *unds E M?1@ million - $?1@ million L @&@6%N F M?@ millionN F M?;A5 millionN
E ?B&; F ?@ F ?;A5 E ?;B1&; million

$#% -et 3ulnera#le *unds E M?55 million - $?55 million L @&@6%N F M?185 millionN F M?87@
millionN
E ?51&67 F ?185 F ?87@ E ?;16&67 million
$c% -et Core *unds E M?6@ million - $?6@ million L @&@6%N F M?5A8 millionN F M?1;5 millionN
E ?5B&1 F ?5A8 F ?1;5 E ?7A9&1 million
herefore> deposit liquidity requirement E @&;8 M?;B1&;N F @&5@ M?;16&67N F @&@8 M?7A9&1N
E ?8B6&;;8 F ?175&99A F ?57&6@8
E ?;9@&;7A million 0R ?;91 million
otal liquidity requirement E additional loan demand F deposit liquidity requirement
Recent e!perience: Currently> loans total ?5>6AB million> #ut recently have #een as high as
?5>89; million> or an additional ?1;A million&
+istorically $#ased on past three years%> loan gro"th has averaged A percent annually&
1nticipated additional loan demand $lo" estimate% E ?5>6AB L 1&@A E ?5>8A@
1nticipated additional loan demand $high estimate% E ?5>89; L 1&@A E ?5>;;5
herefore> additional loan demand could range from ?1B1 million to as much as ?6A6$5;;5-
56AB% million&
11-18
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
otal liquidity requirement $lo" estimate% E ?;91 F ?1B1 E ?B85 million&
otal liquidity requirement $high estimate% E ?;91 F ?6A6 E ?1>177 million&
11-8 4sing the financial information for )atson -ational 2an/> calculates as many of the
liquidity indicators discussed in this chapter for )atson as you can& (o you detect any
significant liquidity trends= )hich trends should management investigate=
Most recent year Previous year
1ssets:
Cash and due from depository
institutions ?678@@@ ?68A>@@@
4&S& reasury securities ?1;9>@@@ ?1;A>@@@
0ther securities ?66B>@@@ ?676>@@@
Pledged securities ?5A;>@@@ ?556>@@@
*ederal funds sold and reverse
repurchase agreements ?1;8>@@@ ?161>@@@
Loans and leases net ?5>17A>@@@ ?1>B7A>@@@
otal 1ssets ?6>5@@>@@@ ?6>@@1>@@@
Lia#ilities:
(emand deposits ?8@@>@@@ ?789>@@@
Savings deposits ?;6@>@@@ ?;51>@@@
ime deposits ?1>1@@>@@@ ?A86>@@@
otal deposits ?5>76@>@@@ ?5>16@>@@@
Core deposits ?A8@>@@@ ?977>@@@
2ro/ered deposits ?8A>@@@ ?6;>@@@
*ederal funds purchased and
repurchase agreements ?51;>@@@ ?56;>@@@
0ther money mar/et #orro"ings ?58>@@@ ?19>@@@
11-19
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
Cash and due from depository
institutions ?678>@@@ ?68A>@@@
4&S& reasury securities ?1;9>@@@ ?1;A>@@@
0ther securities ?66B>@@@ ?676>@@@
Pledged securities ?5A;>@@@ ?556>@@@
*ederal funds sold and reverse
repurchase agreements ?1;8>@@@ ?161>@@@
Loans and leases -et ?5>17A>@@@ ?1>B7A>@@@
otal 1ssets ?6>5@@>@@@ ?6>@@1>@@@
Lia#ilities:
(emand deposits ?8@@>@@@ ?789>@@@
Savings deposits ?;6@>@@@ ?;51>@@@
ime deposits ?1>1@@>@@@ ?A86>@@@
otal deposits ?5>76@>@@@ ?5>16@>@@@
Core deposits ?A8@>@@@ ?977>@@@
2ro/ered deposits ?8A>@@@ ?6;>@@@
*ederal funds purchased and
repurchase agreements ?51;>@@@ ?56;>@@@
0ther money mar/et #orro"ings ?58>@@@ ?19>@@@
Most Recent Qear Previous Qear
Cash position indicator: 678>@@@J6>5@@>@@@ 68A>@@@J6>@@1>@@@
Cash and due from #an/sJotal assets E &1@;A E &11B6
Liquid securities indicator: 1;9>@@@J6>5@@>@@@ 1;A>@@@J6>@@1>@@@
4&S& Govt& sec& J otal assets E&@88 E&@8B6
-et federal funds position: $1;8>@@@-51;>@@@%J6>5@@>@@@ $161>@@@-56;>@@@%J6>@@1>@@@
$*ed funds sold-*ed funds purchased% E-&@161 E-&@686
Jotal 1ssets
Capacity ratio: 5>17A>@@@J6>5@@>@@@ 1>B7A>@@@J6>@@1>@@@
-et loans and leasesJotal assets E&9;16 E&97B1
Pledged security ratio: 5A;>@@@J818>@@@ 556>@@@J851>@@@
Pledged securitiesJotal securities E&88; E&75A
+ot Money Ratio: 678>@@@F1;9>@@@F1;8>@@@ 68A>@@@F1;A>@@@F161>@@@
Money m/t assetsLJ3olatile lia#ilities 51;>@@@ F 58>@@@ 56;>@@@ F 19>@@@
Cash> 4&S& Govt Sec&> *ed *unds Sold E5&AA < E5&97 <
11-1;
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
(eposit #ro/erage inde! 8A>@@@J5>76@>@@@ 6;>@@@J5>16@>@@@
2ro/ered depositsJotal deposits E&@56B E&@1;7
(eposit Composition Ratio 8@@>@@@J1>1@@>@@@ 789>@@@JA86>@@@
(emand depositsJime deposits E&7878 E&8679
Core deposit ratio A8@>@@@J6>5@@>@@@ 977>@@@J6>@@1>@@@
Core depositsJotal assets E&5989 E&5179
)atson appears to have mi!ed liquidity trends> though most indicators reflect declining liquidity&
Cash assets are falling relative to total assets> though holdings of 4&S& Government securities are
rising relative to total assets& -et loans are rising> squee:ing out some liquid assets from total
assets and more of the government securities the #an/ holds are no" pledged to #ac/
government deposits and> therefore> are not availa#le for liquidity needs& 1nother area of
concern that needs managementHs attention is the near tripling in the proportion of deposits
coming from security #ro/ers& 1 comforting offsetting trend> ho"ever> is the decline in volatile
demand deposits relative to more sta#le time deposits&
11-9& he 2an/ of Qour (reams has a simple #alance sheet& he figures are in millions of
dollars as follo"s:

1ssets Lia#ilities and ,quity
Cash ?1@@ (eposits ?7@@@
Securities 1>@@@ 0ther lia#ilities 8@@
Loans 7>@@@ ,quity 9@@
otal assets 8>1@@
otal Lia#ilities and
equity 81@@
1lthough the #alance sheet is simple> the #an/Ds manager encounters a liquidity challenge "hen
depositors "ithdra" ?8@@ million&
a& .f asset conversion method is used and securities are sold to cover the deposit drain>
"hat happens to the si:e of 2an/ of Qour (reams=
#& .f lia#ility management is used to cover the deposit drain "hat happens to the si:e of
2an/ of Qour (reams=
a& .n this case> the #an/ "ould shrin/ #y the amount of deposit "ithdra"als& hus total
assets "ould decrease to ?8>1@@ K 8@@ E ?7>9@@&
#& here "ould #e no change in the si:e of the #an/&
11-1A
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-;& he liquidity manager for the 2an/ of Qour (reams needs cash to meet some
unanticipated loan demand& he loan officer has ?9@@ million in loans that he "ants to ma/e&
4se the simplified #alance sheet provided in the previous pro#lem to ans"er the follo"ing
questions:
a& .f asset conversion is used and securities are sold to provide money for the loans> "hat
happens to the si:e of the 2an/ of Qour (reams=
#& .f lia#ility management is used to provide funds for the loans> "hat happens to the si:e
of the 2an/ of Qour (reams=
a& Since securities are simply replaced #y loans there "ill #e no change in si:e
#& .n this case> the si:e of the #an/ "ould increase #y the amount of total ne" loans&
hus> otal assets "ould increase to ?8>1@@ F 9@@ E ?8>;@@
11-A& Suppose 3ictoria Savings 2an/Hs liquidity manager estimates that the #an/ "ill
e!perience a ?6;8 million liquidity deficit ne!t month "ith a pro#a#ility of 1@ percent> a ?5@@
million liquidity deficit "ith a pro#a#ility of 7@ percent> a ?1@@ million liquidity surplus "ith a
pro#a#ility of 6@ percent> and a ?58@ million liquidity surplus #earing a pro#a#ility of 5@
percent& )hat is this savings #an/Ds e!pected liquidity requirement= )hat should management
do=
Liquidity (eficits or
Surpluses
1ssociated
Pro#a#ilities
-?6;8 million 1@R
-?5@@ million 7@
F?1@@ million 6@
F?58@ million 5@
1@@R
he #an/Hs e!pected liquidity requirement is:
,!pected Liquidity Requirement E @&1@ L$-?6;8 million% F @&7@ L $-?5@@ million% F
@&6@L $F?1@@ million% F @&5@ L $F?58@ million%
E -?6;&8 million - ?A@ million F ?6@ million F ?8@ million
E -?6;&8 million
*aced "ith a e!pected liquidity deficit the #an/Hs liquidity manager must still #egin preparing for
meeting the institutionHs cash needs through arranging for credit lines or deposits from other
#an/s and actual or potential deposit customers and strengthening the #an/Hs liquid asset
position&
11-1B
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-B& *irst Savings of Rain#o"> .o"a> reported transactions deposits of ?;8 million $the daily
average for the latest t"o-"ee/ reserve computation period%& .ts nonpersonal time deposits over
the most recent reserve computation period averaged ?6; million daily> "hile vault cash
averaged ?@&B8 million over the vault-cash computation period& 1ssuming that reserve
requirements on transaction deposits are 6 percent for deposits over ?B&6 million and up to ?76&B
million and 1@ percent for all transaction deposits over ?76&B million "hile time deposits carry a
6 percent required reserve> calculate this savings institutionDs required daily average reserve at
the *ederal Reserve 2an/ in the district&
(aily required reserves at *edE M$?76&B-B&6%L@&@6N F M$?;8 K ?76&B%L&1@N F M?6; L @&@6N -?@&B8
E ?1&@6A F ?6&11 F ?1&11 - ?@&B8 E ?8&58A- ?@&B8 E ?7&6@A million
11-1@& ,lton +ar#or 2an/ has a cumulative legal reserve deficit of ?77 million at the *ederal
Reserve #an/ in the district as of the close of #usiness this uesday& he #an/ must cover this
deficit #y the close of #usiness tomorro" $)ednesday%&
Charles il#y> the #an/Hs money des/ supervisor> e!amines the current distri#ution of money
mar/et and long-term interest rates and discovers the follo"ing:
Money Mar/et .nstrument Current Mar/et Qield
*ederal funds 1&BAR
2orro"ing from the central #an/Ds discount
"indo"
5&58
Commercial paper $one-month maturity% 5&66
2an/erHs acceptances $three-month maturity% 5&6@
Certificates of deposit $one-month maturity% 5&85
,urodollar deposits $three-month maturity% 6&@@
4&S& reasury #ills $three-month maturity% 1&A8
4&S& reasury notes and #onds $1-year maturity% 5&8;
4&S& reasury notes and #onds $8-year maturity% 6&98
4&S& reasury notes and #onds $1@-year maturity% 7&1B
0ne "ee/ ago> the #an/ #orro"ed ?5@ million from the *ederal ReserveHs discount "indo">
"hich it paid #ac/ yesterday& he #an/ had a ?8 million reserve deficit during the previous
reserve maintenance period& *rom the #an/Hs standpoint> "hich sources of reserves appear to #e
the most promising= )hich source "ould you recommend to cover the #an/Hs reserve deficit=
)hy=
11-5@
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
he array of interest rates given in this pro#lem suggests a num#er of "ays ,lton +ar#or 2an/
could meet its reserve requirements& *ederal funds #orro"ing currently is relatively cheaper than
most other short-term sources of funds at an annual rate of 1&BA percent& he #an/ only has to
#orro" for 57 hours and can return the #orro"ed funds on hursday> thus incurring only one
dayHs interest cost& ,lton may also #e a#le to #orro" at the *ederal ReserveHs discount "indo" at
the relatively cheap interest cost compare to other source at 5&58 percent> e!cept that it has Cust
repaid a *ed loan and may have #orro"ed recently& .t "ould #e good if a C( customer or a
reasury #ills $three-month maturity% could #e found to supply a total of ?7@F million& he
*ederal funds mar/et appears to #e the #est near term source of reserves in case no C( customer
or reasury #ills holder found&
11-11& G"ynnDs .sland 2uilding and Loan 1ssociation estimates the follo"ing information
regarding this institutionDs reserve position at the *ederal Reserve for the reserve maintenance
period that #egins today $hursday%:
Calculated required daily average #alance at the *ederal Reserve 2an/ E ?;9@ million
1 loan received #y the *edHs discount "indo" a "ee/ ago that comes
due on *riday $day B% E ? ;@ million
Planned purchases of 4&S& reasury securities on #ehalf
of the association and its customers:
omorro" $*riday% E ? A@ million
-e!t )ednesday $day ;% E ? 68 million
-e!t *riday $day B% E ? 1A million
G"ynnDs .sland also had a closing reserve deficit in the preceding reserve maintenance period of
?8 million& )hat pro#lems are li/ely to emerge as this savings association tries to manage its
reserve position over the ne!t t"o "ee/s= Relying on the *ederal funds mar/et and loans from
the *ederal ReserveDs discount "indo" as tools to manage its reserve position> carefully
construct a pro forma daily "or/sheet for this associationDs money position over the ne!t t"o
"ee/s& .nsert your planned adCustments in discount "indo" #orro"ing and *ederal funds
purchases and sales over the period to sho" ho" you plan to manage G"ynnDs .slandDs reserve
position and hit your desired reserve target&
11-51
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
Chec/ clearing estimates over the ne!t 17 days are as follo"s:
(ay
Credit 2alance
in Millions $F%
(e#it 2alance
in Millions $-%
1 F1@
5 -9@
6 Closed
7 Closed
8 -7@
9 -58
; F6@
A -78
B -8
1@ Closed
11 Closed
15 F5@
16 -;@
17 F1@
(ay
,st&
(aily
1vg
Res&
2al&
Req
Chec/
Clear-
*ederal
*unds
rans&
Purchases
$F%
Sales $$-%
*ederal
(iscount
)indo"
2orro"
$F%
Repay$-%
reas&
Sec&
Red& $F%
Purch $-%
Clos-
ing
(aily
1vg&
2al&
,!cess
or
(eficit
in
Legal
Res&
Cum&
,!c&
or
(ef&
Cum&
Closing
Res&
2al&
at *ed&
(eficit from Previous Period - ?8 mill
1 $hurs% ?;9@ F1@ ?;98 F8 F8 ;98
5 $*ri% ?;9@ -9@ F5@8 -A@ A6@ ;@ ;8 18B8
6 $Sat% ?;9@ A6@ ;@ 178 5758
7 $Sun% ?;9@ A6@ ;@ 518 6588
8 $Mon% ?;9@ -7@ -5@8 8A8 -1;8 7@ 6A7@
9 $ues% ?;9@ -58 89@ -5@@ -19@ 77@@
; $)eds% ?;9@ F6@ -68 888 -5@8 -698 7B88
A $hurs% ?;9@ -78 81@ -58@ -918 8798
B $*ri% ?;9@ -8 F6@@ F56@ -1A 1@1; F58; -68A 97A5
1@ $Sat% ?;9@ 1@1; F58; -1@1 ;7BB
11 $Sun% ?;9@ 1@1; F58; F189 A819
15 $Mon% ?;9@ F5@ -6@@ ;6; -56 F166 B586
16 $ues% ?;9@ -;@ 99; -B6 F7@ BB5@
17 $)ed% ?;9@ F1@ F76 ;5@ -7@ @ 1@>97@
11-55
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
.n this case the #an/Hs money des/ manager tried to avoid deepening deficits #y periodically
particularly on *ridays - #orro"ing heavily in the *ederal funds mar/et and at the *ederal
Reserve #an/& 1nd fortunately> ho"ever> #y the #eginning of the last day $)ednesday% of the
reserve settlement period the #an/ has a cumulative deficit of ?@ million& he planned #orro"ing
in *ederal funds "ill #e enough to prevent any deficit position& .t "ill have a cumulative reserve
#alance of ?1@>97@ million as of the final )ednesday in the settlement period and under the la"
must have a cumulative reserve #alance slightly in e!cess of ?;9@ million L 17 or ?1@>97@
million& Clearly this institution has managed its reserve position "ell&
11-15& Lathrop 2an/ and rust Co& has calculated its daily average deposits and vault cash
holdings for the most recent t"o-"ee/ computation period as follo"s:
-et transaction deposits E ? A;>78;>68@
-onpersonal time deposits under
1A months to maturity E ?19A>B76>8A@
,urocurrency lia#ilities E ? ;>67@>51@
(aily average #alance in vault cash E ? 1>8@@>@;8&
Suppose the reserve requirements posted #y the 2oard of Governors of the *ederal Reserve
System are as follo"s:
-et transaction accounts:
?B&6 to ?76&B million 6R
More than ?76&B million 1@R
-onpersonal time deposits:
Less than 1A months 6R
1A months or more @R
,urocurrency lia#ilities-all types 6R
)hat is this savings #an/Hs total required level of legal reserves= +o" much must the #an/ hold
on a daily average #asis "ith the *ederal Reserve #an/ in its district=
Solution:
M$?76&B million-B&6 million% L @&@6N F M$?A;>78;>68@ - ?76&B million% L @&1@N
F M$?19A>B76>8A@ F ?;>67@>51@% L @&@6N
E ?1>@6A>@@@ F ?7>688>;68 F ?8>5AA>817 E ?1@>9A5>57B
(aily average reserve holdings: ?1@>9A5>57B - ?1>8@@>@;8 E ?B>1A5>1;7
11-56
Chapter 11 - Liquidity and Reserves Management: Strategies and Policies
11-16& *rost Street -ational 2an/ currently holds ?;8@ million in transaction deposits su#Cect to
reserve requirements #ut has managed to enter into s"eep account arrangements "ith its
transaction deposit customers affecting ?18@ million of their deposits& Given the current legal
reserve requirements applying to transaction deposits $as mentioned in this chapter%> #y ho"
much "ould *rost StreetDs total legal reserves decrease as a result of these ne" s"eep account
arrangements> "hich stipulate that transaction deposit #alances covered #y the s"eep agreements
"ill #e moved overnight into savings deposits=
Legal Reserve )ould (ecrease E @&@6 L $?76&B - ?B&6% F @&1@ L $?18@ K ?76&B%
E ?1&@6A F ?1@&91
E ?11&97A million
11-17 S"eet#riar Savings 1ssociation maintains a clearing account at the *ederal Reserve 2an/
and agrees to /eep a minimum #alance of ?6@ million in its clearing account& 0ver the t"o-"ee/
reserve maintenance period ending today S"eet#riar managed to /eep an average clearing
account #alance of ?66 million& .f the *ederal funds interest rate has averaged 5&58 percent over
this particular maintenance period> "hat ma!imum amount "ould S"eet#riar have availa#le in
the form of *ederal Reserve credit to help offset any fees the *ederal Reserve might charge this
association for using *ederal Reserve services=
Reserve Credit E 1vg& Clearing 2alance L1nnuali:ed *ed *unds Rate L 17 daysJ69@ days
E ?66>@@@>@@@ L @&@558 L 17 daysJ69@ days
E ?5A>A;8
11-57