1. Chapter 11: Managing Liquidity

2. Meeting Liquidity Needs
Bank liquidity refers to a bank’s capacity to acquire immediately available funds at a reasonable price.
Firms can acquire liquidity in three distinct ways:
Selling assets, new borrowings and new stock issues.
Effectiveness of each liquidity source at meeting liquidity needs depends on:
Market conditions, evidenced by the market’s perception of risk at the institution as well as in the marketplace
Market’s perception of bank management and strategy.
The current economic environment.

3. Holding Liquid Assets
Liquid assets can be easily and quickly converted into cash with minimal loss.
Four basic types of cash assets:
Vault cash, demand deposit balances held at Federal Reserve Banks, demand deposits held at private financial institutions and cash items in process of collection (CIPC).
Cash assets represent a significant opportunity cost for institutions because they earn little interest.
Objective is to minimize cash and only hold what is required by law or for operational needs.

4. Holding Liquid Assets
Cash assets do not satisfy bank’s liquidity needs.
Do not cover unanticipated cash requirements.
Banks hold cash to satisfy four objectives:
Meet customers’ regular transaction needs.
Meet legal reserve requirements.
Assist in the check-payment system.
Purchase correspondent banking services.

5. Holding Liquid Assets Banks own five types of liquid assets:
Cash and due from banks in excess of requirements.
Federal funds sold and reverse repurchase agreements.
Short-term Treasury and agency obligations.
High-quality short-term corporate and municipal securities.
Government-guaranteed loans that can be readily sold.

6. New Borrowing Banks can access liquid funds by borrowing.
Attractive because quick and prices are predictable.
Historically banks had an advantage over non-depository institutions through funding with low-cost deposit accounts.
Use of non-core funding sources adds liquidity risk.
When an institution gets in trouble, lenders and the FHLB withdraw from the market or increase collateral requirements.

7. Objectives of Cash Management
Banks want to hold as few cash assets as possible without creating problems from deposit outflows.
Significant risks in holding too little cash:
Potential liquidity problems and increased borrowing costs.
Difficult to predict timing and magnitude of deposit transactions that influence deposits held.
Deposit inflows raise legal reserve requirements and increase actual reserve assets and correspondent deposits. Deposit outflows do the opposite.

8. Reserve Balances at the Federal Reserve Bank
Banks hold deposits at the Federal Reserve:
because the Federal Reserve imposes legal reserve requirements and deposit balances qualify as legal reserves.
to help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions.

9. Required Reserves and Monetary Policy
Purpose of required reserves is to enable Federal Reserve to control the nation’s money supply.
The Fed has three distinct monetary policy tools:
Open market operations. Sale or purchase of U.S. government securities in the open market is Fed’s most flexible means of carrying out policy objectives.
Discount window borrowing occurs when banks borrow directly from the Feds. Changes in the discount rate directly affect the cost of borrowing.
Changes in the reserve requirement impact the amount that banks can lend.

10. Required Reserves and Monetary Policy
Required Reserves Example:
Required reserve ratio of 10% means a bank with $100 in demand deposits must hold $10 in required reserves.
Thus the bank can lend out only 90% of its deposits.
If the required reserve increases (decreases), the amount that banks can lend decreases (increases).
The amount of deposit balances a bank holds at the Federal Reserve will vary directly with magnitude of reservable bank liabilities.

11. The Impact of Sweep Accounts on Required Reserve Balances
Sweep account enables a bank to shift funds from transactions accounts to MMDAs or other accounts.
Computer dynamically reclassifies balances from a reservable to a nonreservable account.
Two types of retail sweep programs in use today:
Weekend program reclassifies transaction deposits to savings deposits on Friday and back on Monday, cutting reserve requirements almost in half.
Minimum threshold account moves funds between transaction and MMDA account, limited to six per month.

13. The Impact of Sweep Accounts on Required Reserve Balances
Retail sweep accounts not to be confused with business sweep accounts.
Regulation Q prohibits banks from paying interest on business demand deposit accounts.
Commercial sweep account sweeps excess funds from business demand deposits overnight (typically) into nondeposit, interest-earning assets.
These liabilities are not bank deposit accounts or FDIC insured, so they are not subject to reserve requirements.

14. Meeting Legal Reserve Requirements
Required reserves are calculated over a two-week period.
Bank does not have to hold a specific amount of cash each day but a minimum amount over a longer period.
Fed follows a lagged reserve accounting system (LRA) which requires banks to hold reserves against deposit balances from 3-5 weeks earlier.
Facilitates planning but reduces Fed’s ability to control the money supply and may increase interest rate volatility.

15. Meeting Legal Reserve Requirements

16. Meeting Legal Reserve Requirements
Federal Reserve regulation D and M specify minimum reserve requirement for commercial banks.
Three elements of required reserves:
Dollar magnitude of base liabilities.
Required reserve fraction.
Dollar magnitude of qualifying cash assets.
Base liabilities are composed of net transaction accounts.
Bank’s qualifying reserve assets include vault cash, deposits held at the Federal Reserve Banks and deposits held in pass-through accounts at other institutions.

18. Lagged Reserve Accounting
Computation Period (CP):
Consists of two one-week reporting periods beginning on a Tuesday and ending on the second Monday thereafter.
Maintenance Period (MP):
Consists of 14 consecutive days beginning on a Thursday and ending on the second Wednesday thereafter.
Reserve balance requirement to be maintained in any given 14-day MP equals:
Reserve requirement calculated as of the CP ending 17 days prior to the start of the MP minus vault cash as of the same CP used to calculate the reserve requirement.

20. An Application: Reserve Calculation Under LRA
Four steps:
Calculate daily average balances outstanding during the lagged computation period.
Apply the reserve percentages.
Subtract vault cash.
Add or subtract the allowable reserve carried forward from the prior period.

23. Correspondent Banking Services
System of relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent).
Some services are too expensive to provide independently or cannot be provided by respondent banks due to regulatory constraints.
Predominant services purchased fall into three categories:
Check clearing and related services are attractive because respondent bank can reduce float.
Investment services.
Credit related transactions.

24. Correspondent Banking Services
Check collection, wire transfer, coin and currency supply
Loan participation assistance
Data processing services
Portfolio analysis and investment advice
Federal funds trading
Securities safekeeping
Arrangement of purchase or sale of securities
Investment banking services
Loans to directors and officers
International financial transactions

25. Correspondent Banking Services
Community respondent banks have found themselves circumvented by correspondent banks marketing directly to respondent’s customers resulting in:
Unbundling correspondent bank services by purchasing services from more than one correspondent bank.
Forming and buying services from cooperative institutions known as bankers’ banks that provide correspondent banking services only to financial institutions. Bankers’ banks do not market to retail customers and only compete with other correspondent banks.

26. Short-Term Liquidity Planning

27. Managing Float
During any day, more than $100 million in checks drawn on U.S. banks waiting to be processed.
Customers deposit checks but cannot use the proceeds until banks gives approval, typically in several days.
Checks in process of collection, called float, are a source of both income and expense to banks.
Deposit institutions float with EFTs by authorizing payments is excess of their balances.
Negative balances called daylight overdrafts are generally covered by the end of each day.

28. Managing Float
Overdrafts could potentially close down the electronic payment system.
Primary risk is that some bank might fail because it cannot meet a payment obligation.
Failure might produce liquidity problems at other banks resulting in a ripple effect.
EFT participants required to maintain positive balances at the Fed and correspondent banks at the end of each day.
Daylight overdrafts are costless to deficient banks because no interest or fees are paid.

29. Liquidity versus Profitability
Trade-off between liquidity and profitability.
The more liquid a bank is, the lower its return on equity and return on assets, all other things being equal.
Large holdings of cash assets decrease profits because of the opportunity loss of interest income.
Short-term securities normally carry lower yields than comparable longer-term securities.
Loans carrying the highest yields generally the least liquid.
Liquidity planning focuses on guaranteeing that immediately available funds are available at the lowest cost.

30. The Relationship Between Liquidity, Credit Risk, and Interest Rate Risk
Liquidity risk for a poorly managed bank closely follows credit and interest rate risk.
Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired.
Liquidity planning forces management to monitor overall risk position such that credit risk partially offsets interest rate risk assumed.
Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses.

31. The Relationship Between Liquidity, Credit Risk, and Interest Rate Risk

32. Asset Liquidity Measures
Asset liquidity refers to the ease of converting an asset to cash with a minimum of loss.
Most liquid assets are near term and highly marketable.
Includes cash and due from banks in excess of required holdings, federal funds sold, reverse repurchase agreements, short-term U.S. Treasury and agency securities, highly rated corporate and municipal securities and loans that can be readily sold or securitized.
Liquidity measures are normally expressed in percentage terms as a fraction of total assets.

33. Asset Liquidity Measures
Pledging Requirements:
Not all of a bank’s securities can be easily sold.
Banks are required to pledge collateral against certain types of borrowings.
U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral.
Collateral is required against four different liabilities:
Repurchase agreements, discount window borrowings, public deposits owned by the U.S. Treasury or any state or municipal government unit, FLHB advances

34. Asset Liquidity Measures
Loans:
Many banks and bank analysts monitor loan-to-deposit ratios as a general measure of liquidity.
Loans are presumably the least liquid of assets, while deposits are the primary source of funds.
A high ratio indicates illiquidity because a bank is fully loaned up relative to its stable funding.
A low ratio suggests that a bank has additional liquidity because it can grant new loans financed with stable deposits.

35. Liability Liquidity Measures
Liability liquidity is ease which bank can issue debt to acquire clearing balances at reasonable costs.
Measures reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities.
Commonly cited ratios:
Total equity to total assets; Loan to deposits
Loan losses to net loans; Reserve for loan losses to loans
Percentage composition of deposits; Total deposits to total assets; Core deposits to total assets
Federal funds purchased and RPs to total assets.
Commercial and other short-term borrowings to total assets.

36. Liability Liquidity Measures
Core Deposits:
Base level of deposits bank expects regardless of the economic environment.
Volatile Deposits:
Difference between actual deposits and base estimate of core deposits.
Bank’s Net Noncore Funding Dependency Ratio:
NCFD = (Noncore liabilities- short-term assets)/(long-term assets)
Positive value indicates the bank is highly liquid while a negative value indicates relative illiquidity because volatile, purchased funding exceeds short-term assets.

37. Basel III and the Liquidity Coverage Ratio
Effective in 2015, Federal Reserve Board of Governors, FDIC, and OCC proposed internationally active banks meet minimum liquidity requirement linked to holding of liquid assets:
Impacts banks with $250 billion + in assets or $10 billion + in foreign exposure on balance sheet.
Establishes liquidity coverage ratio (LCR) measured as ratio of high-quality liquid assets to projected net cash outflows.
Objective is to improve large organizations’ liquidity risk management.

38. Longer-Term Liquidity Planning
Involves projecting cash inflows and outflows over 90 days, 180 days, one year and beyond if needed.
Objective is to ensure bank does not face an unanticipated liquidity crisis.
Forecasts in deposit growth and loan demand required.
Projections are separated into three categories: base trend, short-term seasonal, and cyclical values.
Analysis assesses a bank’s liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals.

41. Longer-Term Liquidity Planning
Bank’s monthly liquidity needs estimated as forecasted change in loans plus required reserves minus forecast change in deposits:
Liquidity needs = Forecasted Δloans + ΔRequired reserves - Forecasted Δdeposits
Positive figure means bank needs additional liquid funds.
Negative figure suggests bank will have surplus funds to invest.
Analysis can be used to identify longer-term trends in fund flow.

45. Considerations in the Selection of Liquidity Sources
Costs should be evaluated in present value terms as interest income and expense may arise over time.
Choice of one source over another often involves an implicit interest rate forecast.

46. Contingency Funding Plans
Financial institutions must have carefully designed contingency plans that:
Address strategies for handling unexpected liquidity crises.
Outline appropriate procedures for dealing with liquidity shortfalls occurring under abnormal conditions.

47. Contingency Planning A contingency plan should include:
Narrative section addressing senior officers responsible for dealing with external constituencies, internal and external reporting requirements, and events that trigger specific funding needs.
Quantitative section assessing the impact of potential adverse events on bank’s balance sheet:
Should incorporate timing of events by assigning run-off rates, identify potential sources of new funds and forecast associated cash flows across numerous short and long term scenarios and time intervals, including a wide range of potential internal crises.

48. Contingency Planning A contingency plan should include:
Section summarizing key risks and potential sources of funding, identifying how the modeling will monitored and tested, and establishing relevant policy limits.
Liquidity contingency strategy should clearly outline actions needed to provide the necessary liquidity.
Plan must consider cost of changing asset or liability structure versus the cost of facing a liquidity deficit.

49. Contingency Planning
Should prioritize which assets would have to be sold in the event a crisis intensifies.
Relationship with liability holders should be factored into contingency strategy.
Should provide for back-up liquidity.
Must have specific action steps and establish lines of decision-making authority.
Should be approved by board of directors.
Difficult because when plan is being made because probability of needing it seems remote.