Liquidity & Reserve Management Strategies & Policies
Supplies of Liquidity Flowing into Banks.
n Incoming deposits.
n Revenues from the sale of nondeposit services.
n Customer loan repayments.
n Sales of bank assets.
n Borrowings from the money market.
Demands on the Bank for Liquidity
n Deposits withdrawals.
n Volume of acceptable loan requests.
n Repayment of bank borrowings.
n Other operating expenses.
n Dividend payments to bank stockholders.
Net Liquidity Position (Lt)
n The difference between the total supply of liquidity flowing into a bank & the demands made upon the bank for liquidity. The most pressing demands for spendable funds come from two sources:
n Customers withdrawing money from their deposit.
n Credit requests from customers.
Implications of Liquidity Management
ü Rarely are the the demands for bank liquidity equal to the supply of liquidity at any particular point of time.
ü There is a trade-off between bank liquidity & profitability. High degree of liquidity will reduce the bank’s expected profitability.
Why banks face significant liquidity problem?
n Imbalance between the maturity dates on their assets & the maturity dates attached with their liabilities, i.e, high proportion of demand deposit & high proportion of long-term lending.
n Sensitivity to changes of interest rates. If other banks offer high interest rate, some customer will withdraw their funds for better returns elsewhere.
n Bank’s attitude towards lending & providing services to the depositors.
Strategies for Liquidity Managers
n Providing liquidity from assets (Asset Liquidity Management).
n Relying on borrowed liquidity to meet cash demands (Liability Management).
n Balanced Liquidity Management (Asset & Liability).
1) Asset Liquidity Management Strategies
n Reliance on liquid assets that can be readily sold for cash to meet a bank’s liquidity needs. A liquid asset must have three characteristics:
– Ready Market.
– Stable Price.
– Reversible.
n This strategy is used mainly by small banks that find it a less risky approach than relying on borrowings.
Implications of Asset Liquidity Management Strategies
Ø Selling assets means the bank loses the future earnings possibility.
Ø Selling assets involve transaction cost paid to the security brokers.
Ø Asset in question may need to be sold in a market experiencing declining prices. (capital loss possibility)
Ø Selling assets tends to weaken the appearance of the bank’s balance sheet.
Ø Liquid assets generally holds lowest rate of return,i.e, by investing in liquid assets, banks are ignoring the possibility of higher return on other financial assets.
2)Borrowed Liquidity Management Strategies
n Reliance upon borrowed funds to meet a bank’s liquidity needs. The sources of borrowed funds:
ü Federal funds borrowing.
ü Repos.
ü Issuing large negotiable CDs to major corporation, government & wealth individuals.
ü Issuing Eurocurrency deposits.
ü Borrowing reserves from the discount of the central bank.
q This is the most risky approach to solving liquidity problems because of the volatility of money market interest rates & the rapidity with which the availability of credit can change.
3) Balanced Liquidity Management Strategies
n The combined use of liquid asset holdings & borrowed liquidity to meet a bank’s liquidity needs.
Estimating A Bank’s Liquidity Needs
n Three approaches in measuring or estimating a bank’s liquidity needs:
n The sources & uses of fund approach.
n The structure of funds approach.
n Liquidity indicator approach.
1) The Sources & Uses of fund approach.
n A method for estimating a bank’s liquidity requirements by focusing primarily on expected changes in deposits & loans. The approach begins with two simple facts:
v Bank liquidity rises as deposits increase & loans decrease.
v Bank liquidity declines when deposits decrease & loans increase.
§ Estimated liquidity deficit (-) or surplus (+) for the coming period = estimated changes in total deposits (D) – estimated change in total loans (L)
2) The Structure of Funds Approach
n A method for estimating a bank’s liquidity needs by dividing its borrowed funds into categories based upon their probability of withdrawal. The categories are:
n “Hot Money Liabilities”: Deposits & Non Deposit Borrowed funds that are very interest sensitive & will be withdrawn during the current period.
n Vulnerable Funds: Customer deposits of which a substantial portion (25%-30%) will probably be removed during the current period.
n Stable Funds: Most unlikely to be removed during the current period.
The Structure of Funds Approach…contd.
n Total Liquidity Requirement for a Bank = 0.95 X (Hot money funds – legal reserves held) + 0.30 X (Vulnerable deposits – legal reserves held) + 0.15 X (Stable deposits – legal reserves held) + 1.00 X (Potential loans outstanding – Actual Loans outstanding)
3) Liquidity Indicator Approach
n Cash position indicator = cash & deposits due from depository institutions / total assets.
n Liquid securities indicator = government securities / total assets.
n Net federal funds position = federal funds sold – federal funds purchased.
n Capacity ratio = net loans & leases / total assets.
n Pledged securities ratio = pledged securities / total securities holdings.
n Hot money ratio = money market assets / money market liabilities.
Liquidity Indicator Approach…contd.
n Deposit brokerage index = brokered deposits / total deposits.
n Core deposit ratio = core deposits / total assets.
n Deposit composition ratio = demand deposits / time deposits.
n These indicators are highly sensitive to the season of the year & the stage of the business cycle. Liquidity indicator often decline at boom period due to high loan demand & vice versa.
Legal Reserves & Money Position Management
n Legal reserves are the assets that a central bank requires depository institutions to hold as a reserve behind their deposits or other liabilities.
n Total required legal reserves = {reserve requirements on transaction deposits X daily average amount of net transaction deposits over a designated period} + {reserve requirements on nontransaction reservable liabilities X daily average amount of nontransaction reservable liabilities }