1. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter 12 Liquidity and Reserve Management Strategies and Policies The purpose of this chapter is to explore the reason’s why banks often face heavy demands for immediately spendable funds (liquidity) and learn about the methods banks can use to prepare for meeting their cash needs.

3. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Liquidity The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost

4. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

5. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Demands for Bank Liquidity Customer Deposit Withdrawals Credit Requests from Quality Loan Customers Repayment of Nondeposit Borrowings Operating Expenses and Taxes Payment of Stockholder Dividends

6. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. A Bank’s Net Liquidity Position L = Supplies of Liquid Funds - Demands for Liquidity

7. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Essence of Liquidity Management Rarely are the Demands for Liquidity Equal to the Supply of Liquidity at Any Particular Moment. The Bank Must Continually Deal with Either a Liquidity Deficit or Surplus There is a Trade-Off Between Bank Liquidity and Profitability. The More Bank Resources are Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Bank’s Expected Profitability.

8. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Why Banks Face Significant Liquidity Problems Imbalances Between Maturity Dates of Their Assets and Liabilities High Proportion of Liabilities Subject to Immediate Repayment Sensitivity of Bank to Changes in Interest Rates Central Role in the Payment Process

9. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Strategies for Liquidity Managers Asset liquidity Management or Asset Conversion Strategy Borrowed Liquidity or Liability Management Strategy Balanced Liquidity Strategy

10. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Asset Liquidity Management This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed

11. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

12. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Bankers’ Acceptances Commercial Paper Eurocurrency Loans

13. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

14. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Borrowed Liquidity Management This Strategy Calls for the Bank to Purchase or Borrow from the Money Market To Cover All of Its Liquidity Needs

15. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Sources of Borrowed Funds Federal Funds Purchased Selling Securities for Repurchase (Repos) Issuing Large CDs (Greater than $100,000) Issuing Eurocurrency Deposits Borrowing Reserves from the Discount Window of the Federal Reserve

16. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Balanced Liquidity Management Strategy The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet a Bank’s Liquidity Needs

17. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

18. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Methods for Estimating a Bank’s Liquidity Needs Sources and Uses of Funds Approach Structure of Funds Approach Liquidity Indicator Approach Signals from the Marketplace

19. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Bank’s Net Liquid Funds By Comparing the Estimated Change in Loans to the Estimated Change in Deposits

20. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Structure of Funds A Bank’s 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

21. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Customer Relationship Doctrine Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships

22. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Liquidity Indicator Approach Cash Position Indicator Liquid Security Indicator Net Federal Funds Position Capacity Ratio Pledging Securities Ratio Hot Money Ratio Short-Term Investments to Sensitive Liabilities Ratio Deposit Brokerage Index Core Deposit Ratio Deposit Composition Ratio

23. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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

24. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Legal Reserves Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities

25. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. U.S. Legal Reserve Requirements 3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $44.3 Million 10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $44.3 Million Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments The $44.3 Million Amount is Adjusted Annually

26. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Sweep Account A Contractual Account Between Bank and Customer that Permits the Bank to Move Funds Out of a Customer’s Checking Account Overnight in Order to Generate Higher Returns for the Customer and Lower Reserve Requirements for the Bank

27. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Reserve Computation Period The Period of Time Over Which a bank Calculates its Legal Reserve Requirement

28. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Reserve Maintenance Period The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands

29. Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Factors to Consider When Choosing Among Different Sources of Reserves Immediacy of Bank’s Needs Duration of Bank’s Needs Bank’s Access to Market for Liquid Funds Relative Costs and Risks of Alternatives Interest Rate Outlook and Shape of the Yield Curve Monetary Policy Outlook and Government Borrowing Hedging Capability Regulations Applicable for Liquidity Sources