1. Liability and Liquidity Management
Chapter 18
Liability and Liquidity Management

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.

3. Liquid Asset Management
Examples: T-bills, T-notes, T-bonds
Benefits of holding large quantities of liquid assets
Costs of holding liquid assets

4. Liquid Asset Management
Reasons for regulating minimum holdings of liquid assets:
Monetary policy
Taxation

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 buffer reserves.

6. Return-Risk Trade-off
Cash immediacy versus reduced return
Constrained optimization
Privately optimal reserve holdings
Regulator imposed reserve holdings

7. U.S. Cash Reserve Requirements
Incremental reserve requirements for transaction accounts:
First $5.5 million %
$5.5 million to $42.8 million 3.0%
$42.8 million %

8. Web Resources For information on reserve requirements, visit
Federal Reserve
Web Surf

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.
“Weekend Game”
Sweep accounts

10. Reserve Management
The reserve maintenance period, differs from the computation period by 17 days.
Lagged reserve accounting as of July 1998.
Previously, contemporaneous (2-day lag).
Benefits of lagged reserve accounting

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

12. Undershooting
DI has two options near the end of the maintenance period
Liquidate assets
Borrow reserves
fed funds
repurchase agreements

13. Discount Window Reserve shortfalls in the past
Discount window borrowing
discount rate usually lower than market rates
Risks of gaming the system

14. Overshooting First 4 percent can be carried forward to next period
Excess reserves typically low due to opportunity costs
Knife-Edge problem

15. Funding Risk versus Cost
Funding Cost
Funding Risk

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.

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. 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.

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. (as high as 30% and lows close to 0% on some Wednesdays).
Rollover risk

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

21. Other Borrowings Bankers acceptances Commercial paper
Medium-term notes
Discount window loans

22. Historical Notes
Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid.
Securitization of DI loans
In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.

23. Historical Notes During the period since 1960:
Noticeable differences between large and small banks with respect to use of low withdrawal risk funds.
Reliance on borrowed funds does have its own risks as with Continental Illinois.

24. Liquidity Risk in Other FIs
Insurance companies
Diversify across contracts
Hold marketable assets
Securities firms
Example: Drexel Burnham Lambert

25. Pertinent Website
Federal Reserve Bank
Web Surf