18-2 Overview Depository institutions and life insurance companies are highly exposed to liquidity risk. This chapter discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.
18-3 Liquid Asset Management Examples: T-bills, T-notes, T-bonds Benefits of holding large quantities of liquid assets Costs of holding liquid assets Regulatory requirements for minimum levels of liquid assets
18-4 Liquid Asset Management Reasons for regulating minimum holdings of liquid assets: Monetary policy Multiplier effect of changes in reserve requirements Taxation Due to absence of interest on reserves requiring reserves constitutes transfer of a resource to the central bank. Note interesting responses such as sweep programs
18-5 Composition Composition of liquid asset portfolio Liquid assets ratio Cash and government securities in countries such as U.K. Similar case for U.S. life insurance companies (regulated at state level) U.S. banks: cash-based, but banks view government securities as secondary, or buffer reserves.
18-7 U.S. Cash Reserve Requirements Incremental reserve requirements for transaction accounts: Less than $8.5 million 0.0% $8.5 million to $45.8 million 3.0% Over $45.8 million 10.0%
18-8 Web Resources For information on reserve requirements, visit Federal Reserve
18-9 Reserve Management Problem Computation period runs from a Tuesday to a Monday, 14 days later. Average daily reserves are computed as a fraction of the average daily deposits over the period. This means that Friday deposit figures count 3 times in the average for the week. In the past, “Weekend Game” Sweep accounts
18-10 Reserve Management The reserve maintenance period, begins 17 days after the end of the computation period (or 30 days after the start of the computation period) Lagged reserve accounting as of July Previously, contemporaneous (2-day lag). Benefits of lagged reserve accounting
18-11 Undershooting/Overshooting Allowance for up to a 4% error in average daily reserves without penalty. Surplus reserves required for next 2-week period Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall. Frequent undershooting likely to attract scrutiny by regulators
18-12 Undershooting DI has two options near the end of the maintenance period Liquidate assets Borrow reserves fed funds repurchase agreements
18-13 Discount Window Reserve shortfalls in the past Discount window borrowing Primary credit
18-14 Overshooting First 4 percent can be carried forward to next period Excess reserves typically low due to opportunity costs Significant role of investment portfolio in managing liquidity Impact of technology and the Check Clearing for the 21 st Century Act Knife-Edge management problem
18-15 Funding Risk versus Cost Funding Cost Funding Risk
18-16 Liability Management Note the tradeoff between funding risk and funding cost. Demand deposits are a source of cheap funds but there is high risk of withdrawal. NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.
18-17 Deposit Accounts Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month. Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.
18-18 Time Deposits and CDs Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable. Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.
18-19 Fed Funds Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. Fed funds rate can be highly variable Prior to July 1998: especially around the second Tuesday and Wednesday of each period with contemporaneous reserve accounting (as high as 30% and lows close to 0% on some Wednesdays). Rollover risk Continental Illinois Bank, for example.
18-20 Repurchase Agreements RPs are collateralized fed funds transactions. Usually backed by government securities. Can be more difficult to arrange than simple fed funds loans. Generally below fed funds rate
18-21 Other Borrowings Bankers acceptances Commercial paper Medium-term notes Discount window loans
18-22 Historical Notes Since 1960, ratio of liquid to illiquid assets has fallen from about 48% to about 15.59% in But, loans themselves have also become more liquid. Securitization and sales of DI loans In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.
18-23 Historical Notes During the period since 1960: Noticeable differences between large and small banks with respect to use of low withdrawal risk funds. Differences in access to purchased funds and capital markets Reliance on borrowed funds does have its own risks as with Continental Illinois.
18-24 Liquidity Risk in Other FIs Insurance companies Diversify across contracts Hold marketable assets Securities firms Example: Drexel Burnham Lambert
18-25 Pertinent Website Federal Reserve Bank Federal Deposit Insurance Corporation