Liquidity & Reserve Management Strategies & Policies

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 }