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

3. Liquidity
The Availability of Cash in the Amount and at the Time Needed at a Reasonable Cost

4. 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. Demands for Liquidity Customer Deposit Withdrawals
Credit Requests from Quality Loan Customers
Repayment of Nondeposit Borrowings
Operating Expenses and Taxes
Payment of Stockholder Dividends

6. A Financial Firm’s Net Liquidity Position
L = Supplies of Liquid Funds
- Demands for Liquidity

7. Essence of Liquidity Management
Rarely are the Demands for Liquidity Equal to the Supply of Liquidity at Any Particular Moment. The Financial Firm Must Continually Deal with Either a Liquidity Deficit or Surplus
There is a Trade-Off Between Bank Liquidity and Profitability. The More Resources are Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Financial Firm’s Expected Profitability.

8. Why Banks and Their Competitors Face Significant Liquidity Problems
Imbalances Between Maturity Dates of Their Assets and Liabilities
High Proportion of Liabilities Subject to Immediate Repayment
Sensitivity to Changes in Interest Rates
Central Role in the Payment Process

9. Strategies for Liquidity Managers
Asset Liquidity Management or Asset Conversion Strategy
Borrowed Liquidity or Liability Management Strategy
Balanced Liquidity Strategy

10. Asset Liquidity Management
This Strategy Calls for Storing Liquidity in the Form of Liquid Assets and Selling Them When Liquidity is Needed

11. 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. 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. 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. 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. 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. Balanced Liquidity Management Strategy
The Combined Use of Liquid Asset Holdings (Asset Management) and Borrowed Liquidity (Liability Management) to Meet Liquidity Needs

17. 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. Methods for Estimating Liquidity Needs
Sources and Uses of Funds Approach
Structure of Funds Approach
Liquidity Indicator Approach
Signals from the Marketplace

19. 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. 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. Customer Relationship Doctrine
Management Should Strive to Meet All Good Loans that Walk in the Door in Order to Build Lasting Customer Relationships

22. 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. 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. Legal Reserves
Assets That a Central Bank Requires Depository Institutions to Hold as a Reserve Behind Their Deposits or Other Liabilities

25. U.S. Legal Reserve Requirements
3 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts Up To $42.1 Million
10 Percent of End-of-the-Day Daily Average for a Two Week Period For Transaction Accounts For Amounts Over $42.1 Million
Transaction Accounts Include Checking Accounts, NOW Accounts and Other Deposits Used to Make Payments
The $42.1 Million Amount is Adjusted Annually

26. 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. Reserve Computation Period
The Period of Time Over Which a bank Calculates its Legal Reserve Requirement

28. Reserve Maintenance Period
The Period of Time Over Which a Bank Must Hold the Required Amount of Legal Reserves that the Law Demands

29. 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