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LIQUIDITY & RESERVE


MANAGEMENT

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11-2

Liquidity
The Availability of Cash in the Amount and
at the Time Needed at a Reasonable Cost
The size and volatility of cash requirements
affect the liquidity position of the bank
Examples of transaction that affect the
banks cash balance and liquidity position:
Deposits and withdrawals; loan
disbursements and loan payments
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11-3

Supplies of Liquid Funds


Incoming Customer Deposits
Revenues from the Sale of Non-deposit
Services
Customer Loan Repayments
Sales of Bank Assets
Borrowings from the Money Market
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11-4

Demands for Liquidity


Customer Deposit Withdrawals
Credit Requests from Quality Loan
Customers
Repayment of Nondeposit Borrowings
Operating Expenses and Taxes
Payment of Stockholder Dividends
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11-5

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11-6

A Financial Firms Net Liquidity


Position

L =

Supplies of Liquid Funds


- Demands for Liquidity

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11-7

Quick Quiz: Comprehensive Problem


Suppose that a bank faces the following cash inflows and outflows
during the coming week:
a)deposit withdrawals are expected to total Rs.33 million;
b)customer loan repayments are expected to amount to Rs.108 million;
c)Operating expenses demanding cash payment will probably
approach Rs.51 million;
d)Acceptable new loan requests should reach Rs.294 million;
e)Sales of bank assets are projected to be Rs.18 million;
f)New deposits should total Rs.670 million;
g)Borrowings from the money market are expected to be about Rs.43
million;
h)Nondeposit service fees should amount to Rs.27 million;
i)Previous bank borrowings totaling Rs.23 million are scheduled to be
repaid; and
j)A dividend payment to bank stockholders of Rs.140 million is
scheduled.
What is this banks projected net liquidity position for the coming
week?
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11-8

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 Liquidity and
Profitability.
The More Resources Tied Up in
Readiness to Meet Demands for Liquidity, the
Lower
is
the
Financial
Firms
Expected
Profitability.

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11-9

Why Banks and Their Competitors


Face Significant Liquidity Problems
Imbalances Between Maturity Dates of Their Assets and
Liabilities
High Proportion of Liabilities (especially demand
deposits and money market borrowings) Subject to
Immediate Repayment
Sensitivity to Changes in Interest Rates

May affect customer demand for deposits


May affect customer demand for loans

Central Role in the Payment Process, Reputation and


Public Confidence in the System
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11-10

Strategies for Liquidity Managers


1. Think about what is a liquid asset?
2. Identify strategies for liquidity management.

Asset Liquidity Management or Asset


Conversion Strategy

Borrowed Liquidity or Liability Management


Strategy

Balanced Liquidity Strategy

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11-11

Asset Liquidity Management

This Strategy Calls for Storing


Liquidity in the Form of Liquid Assets
(T-bills, Central Bank funds loans,
CDs, etc.) and Selling Them When
Liquidity is Needed
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11-12

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
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11-13

Options for Storing Liquidity


Treasury Bills
Central bank Funds
Sold to Other Banks
Purchasing Securities
for Resale (Repos)
Deposits with
Correspondent Banks

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Bonds and Notes


Central bank
Securities
Negotiable
Certificates of
Deposits

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11-14

Asset Liquidity Management is Not


Costless and Include Opportunity
Cost
Loss of Future Earnings on Assets That Must
Be Sold
Transaction Costs (Commissions) 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
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11-15

Borrowed Liquidity (Liability)


Management

This Strategy Calls for the Bank


to Purchase or Borrow from the
Money Market To Cover All of Its
Liquidity Needs
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11-16

Sources of Borrowed Funds

Central Bank Funds Purchased


Selling Securities for Repurchase (Repos)
Issuing Large CDs
Securing Advance from the Central Bank
Home Loan Bank
Borrowing Reserves from the Discount
Window of the Central Bank Reserve

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11-17

Borrowed Liquidity (Liability)


Management Strategy
Advantages

Disadvantages

Highest Expected Return


Borrow Only When There
But Carries the Highest
is a Need for Funds
Risk Due to Volatility of
Volume and Composition
Interest Rates and
of the Investment
Possible Rapid Changes in
Portfolio Can Remain
Credit Availability
Unchanged
Borrowing Cost is Always
The Institution Can
Uncertain-> Uncertain
Control Interest Rates in
Earnings
Order to Borrow Funds
Borrowing Needs Can Be
(raise offer rates when
Interpreted as a Signal of
needs requisite amounts
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11-18

Balanced Liquidity Management


Strategy
The Combined Use of Liquid
Asset Holdings (Asset
Management) and Borrowed
Liquidity (Liability Management)
to Meet Liquidity Needs
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11-19

Guidelines for Liquidity Managers


They Should Keep Track of All FundUsing 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

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11-20

Methods for Estimating Liquidity


Needs
Sources and Uses of Funds Approach
Structure of Funds Approach
Liquidity Indicator Approach
Signals from the Marketplace

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11-21

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
Banks Net Liquid Funds By Comparing the
Estimated Change in Loans to the
Estimated Change in Deposits

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11-22

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11-23

Structure of Funds Approach


A Banks Deposits and Other Sources of
Funds Divided Into Categories.
For
Example:

Hot Money Liabilities (volatile liabilities)


Vulnerable Funds
Stable Funds (core deposits or core liabilities)

Liquidity Manager Set Aside Liquid Funds


According to Some Operating Rule

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11-24

Customer Relationship Doctrine


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

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11-25

Liquidity Indicator Approach


(Based on Experience and Industry
Averages)
Hot Money Ratio
Cash Position Indicator
Liquid Security Indicator

Deposit Brokerage Index

Net Central Bank Funds


Position

Core Deposit Ratio


Deposit Composition Ratio

Capacity Ratio
Loan Commitment Ratio
Pledged Securities Ratio
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11-26

The Ultimate Standard: 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

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11-27

Legal Reserves
Assets That a Central Bank Requires
Depository Institutions to Hold as a
Reserve Behind Their Deposits or
Other Liabilities
Assets Can Be Used for This Purpose:
1) Cash in the Vault; 2) Deposits Held
in a Reserve Account With the
Central bank.

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11-28

Calculating Required Reserves

Any deficit above 4% may be assessed an interest penalty equal to the Central Bank
Reserves discount (primary credit) rate at the beginning of the month plus 2
percentage points applied to the amount of the deficiency.
Repeated reserve deficits lead to increased regulatory scrutiny, possibly damaging its
efficiency.
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11-29

Other Factors to Influence Legal


Reserves
Use of RBI Fund Market

The cheapest source


But very volatile
Managers rely on the Central Bank funds target
rate (the most volatile on the settlement date)

Other Options

Sell liquid securities


Draw upon excess correspondent balances
Enter into repurchase agreements for
temporary borrowings
Sell new time deposits
And borrow in the currency market

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11-30

Factors in Choosing Among


Different Sources of Reserves
Immediacy of Banks Needs
Duration of Banks Needs
Banks Access to Market for Liquid Funds
Relative Costs and Risks of Alternatives
Interest Rate Outlook
Outlook for Central Bank Monetary Policy
Regulations Applicable for Liquidity Sources
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