CHAPTER 11

LIQUIDITY AND RESERVE MANAGEMENT: STRATEGIES AND POLICIES

Meaning of the 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 bank’s cash balance and
liquidity position: Deposits and withdrawals; loan disbursements and loan payments

11 – 2 Demand for and Supply of Liquidity

Supplies of funds stem principally from incoming deposits, sales of bank assets,
particularly money market securities, and repayments of outstanding loans. In general,
supplies of liquidity come from the following sources:
1. Incoming Customer Deposits
2. Revenues from the Sale of Nondeposit Services
3. Customer Loan Repayments
4. Sales of Bank Assets
5. Borrowings from the Money Market
The most pressing demands for liquidity arise principally from customers withdrawing
money from their deposits and credit requests. In general, demand for liquidity comes
from the following uses:
1. Customer Deposit Withdrawals
2. Credit Requests from Quality Loan Customers
3. Repayment of Nondeposit Borrowings
4. Operating Expenses and Taxes
5. Payment of Stockholder Dividends

The net liquidity position at any point in time (Lt) is given as

Lt = Supplies of liquidity fund – demand for liquidity.

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When the demand for liquidity exceeds its supply (Lt < 0), the management must prepare
for liquidity deficit, deciding when and where to raise additional funds. If the supply of
liquidity exceeds all liquidity demands (Lt > 0), management must prepare for liquidity
surplus, deciding when and where to profitably invest surplus liquid funds until they are
needed to cover future cash needs. Most liquidity problems arise from outside of the bank
as a result of the activities of customers.
Liquidity has a critical time dimension. Some liquidity needs are immediate or nearly so.
For example, for a bank several large CDs may be due to mature tomorrow, and the
customer may have indicated they plan to withdraw these deposits rather than simply
rolling them over into new deposits. Sources of funds must immediately be identified.
The longer-term liquidity demands arise from seasonal, cyclical, and trend factors. For
example, liquid funds are generally in greater demands during the fall and summer
coincident with school, holidays, and travel plans. Sources of funds for long-term
liquidity demands may be different than immediate needs. Sources of funds for long-term
liquidity demands could be selling off accumulated liquid assets, aggressively advertising
the institution’s current menu of services, or negotiating long-term borrowing of reserves
from other financial firms. Timing is critical: Financial managers must plan carefully
how, when, and where liquid funds can be raised.

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

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What is this bank’s projected net liquidity position for the coming week?

Cash Inflows Cash Outflows

Customer Loan $108 Deposit Withdrawals $33
Repayments
Sales of Bank Assets 18 Operating Expenses 51
New Deposits 670 New Loan Requests 294
Money-Market Borrowings 43 Repayment of Previous 23
Borrowings
Nondeposit Service Fees 27 Dividend to Stockholders 14
0

Total Cash Inflows $866 Total Cash Outflows $541

Net Liquidity
Position Total Cash Total Cash
Projected for = Inflows - Outflows
the Coming
Week

= $866 million - $541 million

= + $325 million
The essence of liquidity management problems for financial institutions may be
described in two succinct statements:
1. Rarely are demands for liquidity equal to the supply of liquidity at any particular
moment in time. The financial firm must continually deal with either a liquidity
deficit or a liquidity surplus.
2. There is a trade-off between liquidity and profitability. More liquidity implies
lower expected profitability.
A financial institution is adequately liquid if it has adequate cash available precisely
when cash is needed at a reasonable cost. Management can monitor the cash position
over time and monitor as well what is happening to its cost of funds. We could say that
the management of liquidity is subject to the risks that interest rates will change (interest
rate risk) and the liquid funds will not be available in the volume needed (availability
risk). If market interest rates rise, assets that the financial firm plans to sell to raise liquid
funds will decline in value, and some must be sold at a loss. Then, too, raising liquidity
funds by borrowing will cost more as interest rates rise, and some forms of borrowed
liquidity may no longer be available.

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11 – 3: Why do banks and many of their closest financial service competitors face
significant liquidity management problems?

Financial institutions are prone to liquidity management problems due to:

1. Imbalances between maturity dates of their assets and liabilities.
2. Their relatively high proportion of short-term liabilities (especially demand
deposits and money market borrowings subject to immediate repayment) and
relatively long-term financial assets
3. The sensitivity of their assets and liabilities to interest-rate movements. This may
affect customer demand for deposits and customer demand for loans.
4. Central role in the payment process, reputation and public confidence in the
system. Example, if the teller windows and ATMs had to be closed one morning
because the bank was temporarily out of cash and could not cash checks or meet
deposit withdrawals. This damages public confidence and bank runs.

11 – 4 Strategies for Liquidity Managers

Think about what is a liquid asset? Identify strategies for liquidity management: (1) Asset
liquidity management or asset conversion strategy; (2) borrowed liquidity or liability
management strategy; and (3) balanced liquidity strategy.
Asset Liquidity Management (or Asset Conversion) Strategies
This strategy calls for storing liquidity in the form of liquid assets (T-bills, fed funds
loans, CDs, etc.) and selling them when liquidity is needed. When liquidity is needed,
selected assets are converted into cash until all demands for cash are met.
What is a liquid asset? It must have 3 characteristics:
1. Must have a ready market so it can be converted to cash quickly.
2. Must have a reasonably stable price (could be sold quickly without significant
decline in price).
3. Must be reversible so an investor can recover original investment with little risk.
Options for storing liquidity in assets are:
• Treasury Bills
• Fed Funds Sold to Other Banks
• Purchasing Securities for Resale (Repos)
• Deposits with Correspondent Banks
• Municipal Bonds and Notes
• Federal Agency Securities
• Negotiable Certificates of Deposits
• Eurocurrency Loans
Remember: A financial firm is liquid only if it has access, at reasonable cost, to liquid
funds in exactly the amounts required at precisely the time they are needed.

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The asset conversion or asset liquidity management strategy is used mainly by smaller
financial institutions that find it risky approach to liquidity management than relying on
borrowings. 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

Borrowed Liquidity (Liability) Management Strategies

This strategy calls for the bank to purchase or borrow immediately spendable funds from
the money market to cover all of its (anticipated) liquidity needs. The principal sources of
borrowed liquidity are:
• Federal Funds Purchased
• Selling Securities for Repurchase (Repos)
• Issuing Jumbo (Large) CDs (Greater than $100,000)
• Issuing Eurocurrency Deposits
• Securing Advance from the Federal Home Loan Bank
• Borrowing Reserves from the Discount Window of the Federal Reserve

Borrowing liquidity funds has number of advantages follows:

• Borrow only when there is a need for funds (instead of storing liquid assets all
time)
• Volume and composition of the investment portfolio can remain unchanged
• The institution can control interest rates in order to borrow funds (raise offer rates
when needs requisite amounts of funds)

Has number of disadvantages as well such as:

• Highest expected return but carries the highest risk due to volatility of interest
rates and possible rapid changes in credit availability
• Borrowing cost is always uncertain implies uncertain earnings
• Borrowing needs can be interpreted as a signal of financial difficulties

Balanced Liquidity Management Strategy

The combined use of liquid asset holdings (Asset Management) and borrowed liquidity
(Liability Management) to meet liquidity needs. Unexpected cash needs are typically met
from near-term borrowings. Longer-term liquidity needs can be planned for and the funds
to meet these needs can be parked in short-term and medium-term assets that will provide
cash as those liquidity needs arise.
Summary: Asset management is a strategy for meeting liquidity needs, used mainly by
smaller banks, in which liquid funds are stored in readily marketable assets that can be
quickly converted into cash as needed. Liability management involves borrowing enough
immediately spendable funds to cover demands for liquidity made against a bank.

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Balanced liquidity management calls for using both asset management and liability
management to cover a bank's liquidity needs.

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

11 – 5 Estimating Liquidity Needs

Several methods have been developed in recent years for estimating a financial
institution’s liquidity requirements. These are:
• Sources and Uses of Funds Approach
• Structure of Funds Approach
• Liquidity Indicator Approach
• Signals from the Marketplace approach

Sources and Uses of Funds Approach

The sources and uses of funds method for estimating liquidity needs begins with two
simple facts:
1. In the case of a bank, for example, liquidity rises as deposits increase and loans
decrease.
2. Alternatively, liquidity declines when deposits decrease and loan increase.
Whenever sources and uses of liquidity do not match, there is a liquidity gap (positive or
negative), as measured by the size of the difference between sources and uses of funds.

Example: A bank faces the following estimated deposit and loan figures for each of the
next six months: (all figures in millions):
Estimated Total Estimated Total Loans
Deposits
$112 $87
132 95
121 102
147 113
151 101
139 124

Under the sources and uses of funds approach, when does this bank face liquidity deficits,
if any?

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 Estimated
Change in Change in Loans Liquidity
Months Deposits ($) Deficit or Surplus
($) ($)
Month 1 – – –
Month 2 +20 +8 +12
Month 3 -11 +7 -18
Month 4 +26 +11 +15
Month 5 +4 -12 +16
Month 6 -12 +23 -35
Clearly, the bank has projected liquidity surpluses (which should be profitably invested)
for three of the next four months, but a deficit is estimated for the second and last month
which will have to be covered through borrowings and possibly through the sale of liquid
assets.

The key steps in the sources and uses of funds approach, using a bank as an example, are:
• 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 surplus or
deficit for the planning period By Comparing the Estimated Change in Loans (or
other uses of funds) to the Estimated Change in Deposits (or other funds sources).

Banks, for example, use a variety of statistical techniques to prepare forecasts of deposits
and loans. For example a bank may develop the following forecasting models:

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The models can be written using symbols as:
LN te1  f ( g te1 , Ete1 , mt , ( PRte1  CPt e1 ),  te1 )
Dte1  f (Yt e1 , S te1 , mt , DRte1 ,  te1 )
Using the forecasts of loans and deposits generated by the foregoing relationship,
management could then estimate the bank’s need for liquidity by calculating:

Let1  Dte1  LN te1

A somewhat simpler approach for estimating future deposits (or other funds sources) and
loans (or other funds uses) is to divide the forecast of future deposit and loan growth into
three components:
1. A trend component, estimated by constructing a trend line.
2. A seasonal component, measuring how deposits (or other funds sources) and loans
(or other funds uses) are expected behave in a given week or month due to
seasonal factors.
3. A cyclical component, representing positive or negative deviations from a bank’s
total expected deposits and loans depending on position of the business cycle
(strength or weakness of the economy).
Table 11-1 presents a forecast of weekly deposit and loan totals for six weeks and table
11-2 shows how we use them to estimate expected liquidity deficits and surpluses:

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The Structure-of-Funds Approach
In the first step of this approach, deposits and other funds sources are divided into
categories based on their estimated probability of being withdrawn and, therefore, lost to
the bank. A bank’s deposits and non-deposit liabilities into three categories:
1. “Hot Money” liabilities (volatile liabilities) – deposits and other borrowed funds
that are very interest sensitive or that management is sure will be withdrawn
during the current period.
2. Vulnerable Funds – customer deposits of which a substantial portion (25 – 30%)
will probably be withdrawn during the current period.
3. Stable Funds (core deposits or core liabilities) – funds unlikely to be removed.
In the second step, the liquidity manager must set aside liquid funds according to some
desired operating rules for "hot money" liabilities, vulnerable funds, and stable funds. For
example, manager (as an operating rule) may decide to set up a 95% liquid reserve
behind all hot money funds (less any required legal reserves held behind hot money
deposits), as a common rule of thumb set 30% in liquid reserves out of vulnerable funds
and 15% liquid reserves out of stable funds, then liability liquidity reserve is:

Liability liquidity reserve (requirement) = 0.95 × (Hot money liabilities – legal reserve held on
hot money) + 0.30 × (Vulnerable funds – legal reserve
held on vulnerable funds) + 0.15 × (Stable deposits –
legal reserve held on stable deposits).

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In case of loans, a lending institution must be ready at all times to make good loans and
must have sufficient liquid reserves on hand. It does not want to turn down any good
loan, because loan customers bring in new deposits and normally are the principal source
of earnings from interest and fees. Under today’s concept of relationship banking, once
the customer is sold (given) a loan, the lender would be able to sell that customer other
services, establishing a multidimensional relationship that will bring in additional fee
income and increase the customer’s dependence on the lending institution.
Customer Relationship Doctrine: Management Should Strive to Meet All Good Loans
that Walk in the Door in Order to Build Lasting Customer Relationships.
This means the lending institution must hold in liquid reserves or borrowing capacity the
full amount (100 percent) of the difference between potential loan outstanding and actual
loan outstanding. Thus, for example,

Total liquidity requirement = Deposit and nondeposit liability requirement and loan liquidity
requirement = 0.95 × (Hot money liabilities – legal reserve held on hot money)
+ 0.30 × (Vulnerable funds – legal reserve held on vulnerable funds)
+ 0.15 × (Stable deposits – legal reserve held on stable deposits)
+ 1.00 ×(Potential loans outstanding – Actual loans outstanding).

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Problem: Suppose that a thrift institution’s liquidity division estimates that it holds $19
million in hot money deposits and other IOUs against which it will hold an 80 percent
liquidity reserve, $54 million in vulnerable funds against which it plans to hold a 25
percent reserve, and $112 million in stable or core funds against which it will hold a 5
percent liquidity reserve. The thrift expects its loans to grow 8 percent annually; its loans
currently stand at $117 million, but have recently reached $132 million. If reserve
requirements on liabilities currently stand at 3 percent, what is this depository
institution’s total liquidity requirement?

Total Liquidity
Requirement = 0.80 ($19 million - 0.03 x $19 million)

+ 0.25 ($54 million - 0.03 x $54 million)

+ 0.05 ($112 million - 0.03 x $112 million)

+ (0.08 x $132 million + ($132 million - $117 million)

= $58.83 million

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Many financial firms like to use probabilities in deciding how much liquidity to hold the
worst and the best possible liquidity positions.
1. The worst possible liquidity position arises when the actual deposit totals
sometimes go below the lowest points on the bank’s minimum deposit growth
track and the loan demands sometimes goes beyond the high points of the bank’s
loan growth track. In this case the management must be prepared for sizable
liquidity deficit.
2. The best possible liquidity position arises when the actual deposit touches the
highest points on the bank’s deposit growth track and the loan demands touches
the low points of the bank’s loan growth track. A potential source of liquidity
surplus.
Of course, neither the worst nor the best possible outcome is likely for both deposit and
loan growth, so they calculate the expected liquidity requirement, the outcome lies
between these two extremes. As an example, consider the table below:
Possible Estimated Estimated Estimated Probability
liquidity average average loans liquidity assigned to
outcomes for deposits Next Next week surplus or each possible
Next week week deficit Next outcome
week
Best possible
liquidity $170 $110 +$60 15%
position
Liquidity
position bearing
the highest $150 $140 +$10 60%
probability
Worst possible
liquidity $130 $150 –$20 25%
position

Then this financial firm’s expected liquidity requirement must be:

Expected liquidity requirement = 0.15 × (+$60 million) + 0.60 × (+$10 million)

+ 0.25 × (–$20 million)
= +$10 million.
That is, on average the management should plan for a $10 million liquidity surplus next
week and begin now to review the options for investing this expected surplus.

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Liquidity Indicator Approach
Many financial institutions use certain liquidity indicators to estimate their liquidity
needs. Here are some examples:
1. Cash Position Indicator = (Cash and deposits)/(Total assets). A high value of this
ratio means the bank is in strong position to handle immediate cash needs.
2. Liquid securities indicator = (US government securities)/(total assets). The greater the
proportion of government securities, more liquidity position.
3. Net Federal Funds Position = (Federal funds sold and repo – federal funds bought and
repo)/(total assets). Liquidity tends to increase when this ratio increase.
4. Capacity Ratio = (Net loans and losses/total assets). This is a negative liquidity
indicator because loans and losses are the most illiquid assets
5. Pledged Securities Ratio = (Pledged securities)/(total securities holding). The greater
the proportion of securities pledged to back government deposits, the fewer are
securities are available to sell when liquidity needs arise.
6. Hot Money Ratio = (Hot money)/(volatile liabilities). Hot money = cash and due from
deposit held at other depository institutions + holdings of short-term securities +
federal funds loans + reverse repurchase agreements. Volatile liabilities = large CDs +
Eurocurrency deposits + federal funds borrowings + federal funds borrowings +
repurchase agreements. This ratio reflects whether the bank has roughly balanced the
volatile liabilities it has issued with the money market assets it holds that could be
sold quickly to cover those liabilities.
7. Deposit Brokerage Index = (Brokered deposits/total deposits). Brokered deposits are
funds placed by security brokers for their customers as deposit insurance.
8. Core Deposit Ratio = (Core deposits)/(total assets). Core deposits = Total deposits –
all deposits over $100,000. Core deposits are mainly small-denominated checking and
saving accounts that are unlikely to be withdrawn on short notice and so carry lower
liquidity requirements.
9. Deposit Composition Ratio = (Demand deposits)/(time deposits). A decline in this
ratio suggests greater deposit stability and a lesser need of liquidity.
10. Loan Commitment Ratio = (Unused loan commitment)/(total assets). With loan
commitments there is risk as to the exact amount and timing when some portion of
loan commitments become actual loan. The lender must be prepared with sufficient
liquidity to accommodate a variety of “take-down” scenarios that borrowers may
demand. A rise in this ratio implies greater future liquidity needs.
Recent trends (from 1985 to 2005) in most liquidity indicators for FDIC-insured US
banks indicate a recent decline in liquidity. One reason for the apparent decline in
industry liquidity is consolidation – smaller institutions being absorbed by larger
institutions. Because of a fewer but much larger banks, there is a chance that a
withdrawal by a customer would be ended up by a deposit by another customer in the
same bank and as a result no overall change in the bank’s cash position.

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The first five liquidity indicators focus primarily upon assets or stored liquidity. The last
five focus mainly upon liabilities or on future commitments to lend money and are aimed
mainly at forms of purchased liquidity. These indicators tend to be highly sensitive to
season of the year and stage of the business cycle. For example, liquidity indicators often
decline in boom periods under pressure from rising loan demand, only to rise again
during the ensuing business recession.
Summary: The liquidity indicator approach uses tell-tale financial ratios (e.g., total
loans/total assets or cash assets/total assets) whose changes over time may reflect the
changing liquidity position of the financial institution. The ratios are used to estimate
liquidity needs and to monitor changes in the liquidity position.
Problem: First National Bank has the balance sheet entries listed below. How many
liquidity indicators can be calculated from these figures?

Assets Liabilities

Cash Deposits held at Federal Fund Purchased $ 62

other Banks $ 633
U.S. Government securities $ 185 Demand Deposits $ 988
Net Loans and Losses $3,502 Time Deposits $2,627
Federal Funds Sold $ 48
Total Assets $4,446

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The liquidity indicators that we can construct from the foregoing figures include:

Cash Position Indicator:

Cash and Deposits Due from Other = $633 = 14.24 percent

Banks
Total Assets $4446

Net Federal Funds Position:

(Federal Funds Sold – Federal Funds = ($48 - $62) = - 0.31 percent

Purchases)
Total Assets $4446

Capacity Ratio:

Net Loans and Leases = $3,50 = 78.77 percent

2
Total Assets $4446

Deposit Composition Ratio:

Demand Deposits = $988 = 37.61 percent

Time Deposits $2,62
7

Liquid Securities Indicator:

U.S. Government = $385 = 8.66 percent

Securities
Total Assets $4,446

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The Ultimate Standard for Assessing Liquidity Needs: Signals from the
Marketplace
No financial institution can tell for sure if it has sufficient liquidity until it has passed the
market's test or method centers on the discipline of the financial marketplace.
Specifically, management should look at the following signals:
1. Public Confidence. Institution losing money: is it because of the public perception
that it will be unable to pay its obligations.
2. Stock Price Behavior. Falling stock price may indicate of liquidity crisis.
3. Risk Premiums on CDs and other borrowings. Payments of higher interest on these
liabilities may be considered as risk premiums and liquidity crisis.
4. Loss Sales of Assets. Sales of assets in hurry (with significant losses) again may
indicate of liquidity crisis.
5. Meeting Commitments to Creditors. Is it able to honor all requests for potential
profitable loans?
6. Borrowings from the Central Bank. Borrowing in large volume and more frequently
from the central bank indicates liquidity crisis.
If problems exist in any of these areas, management needs to take a close look at its
liquidity management practices to determine whether changes are in order.

11- 6 Legal Reserves and Money-Position Management

The Money Position Manager: A money position manager is responsible for ensuring
that the institution maintains an adequate level of legal reserves.
The money-position manager wants to insure the bank has sufficient legal reserves to
meet its reserve requirements as imposed by the central bank but usually holds no more
than the legal minimum requirement because excess legal reserves yield no income for
the bank.

Legal Reserve: Legal reserves are assets that a Central Bank requires depository
institutions to hold as a reserve behind their deposits or other liabilities.
Only two kinds of assets can be used for this purpose: 1) Cash in the vault; 2) deposits
held in a reserve account with the regional Fed (or, for smaller depository institutions,
deposits held with a Fed-approved institution that passes reserves through to the Fed).
After the money position manager calculates daily average deposits and the institution’s
required legal reserves, he/she must maintain that required legal reserve on deposit with
the Fed in the region on average, over a 14-day period.

Reserve Computation: Exhibit 11 – 1 shows under lagged reserve accounting (LRA)

how the daily average amount of deposits and other reservable liabilities (and also the
vault cash) are computed using information gathered over a two-week period stretching
from a Tuesday through a Monday two weeks later. This interval of time is known as the
reserve computation period.

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Reserve Maintenance: After calculating daily average deposits and required legal
reserves, the money position manager must maintain that required legal reserves on
deposit with the Fed, on average, over a 14 day period stretching from Thursday through
Wednesday – known as reserve maintenance period (exhibit 11 – 1). Note from exhibit
11 – 1 that reserve maintenance period begins after 30 days after the reserve computation
period and there is 16-day lag between these two period.

Reserve Requirements: How much money must be held in legal reserves? The answer
depends on the volume and mix of each institution’s deposits and also on the particular
time period, since the amount changes each year. For the US depository institutions, in
2007-2008,
• First $9.3 Million have 0 Legal Reserves
• 3 Percent of End-of-the-Day Daily Average for a Two Week Period For
Transaction Accounts from $9.3 million To $43.9 Million ($43.9 million is known
as the reserve tranche and changes every year)
• 10 Percent of End-of-the-Day Daily Average for a Two Week Period For
Transaction Accounts For Amounts Over $43.9 Million
• Transaction Accounts Include Checking Accounts, NOW Accounts and Other
Deposits Used to Make Payments
• The $43.9 Million Amount is Adjusted Annually
• The Money Position Manager Oversees the Institution’s Legal Reserve Account

Calculating Required Reserves: Whether large or small, the total required legal
reserves of each depository institution are calculated by the same method. Each
reserveable liability item is multiplied by the assigned reserve requirement percentage to
derive total legal reserve requirement. Thus,

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A simple calculation of a U.S. bank’s total required legal reserves is shown in table 11 –
5.

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Once a bank determines its required reserve amount, it compares this figure to its actual
daily average holdings of legal reserve assets consists of vault cash and its reserve with
Fed.
• If total reserves (TR) > total required legal reserves (RR), the bank has excess
reserve (ER).
• ER = TR – RR.
• RR = Vault cash + Reserve with Fed
• Banks’ try to invest ER quickly because it does not pay interest.
• If TR < RR, the bank has reserve deficit.
• The law requires the bank to cover this deficit by acquiring additional legal
reserves.
• Current law allows a bank to run up to a 4% deficit for the next reserve
maintenance period.

Example:
(Based on: (1) Transaction deposits requirements: first $9.3 million had 0 legal reserves;
from $9.3 to $43.9 million, reserve requirement was 3%. Transaction deposits over $43.9
million carried a 10% reserve requirement; (2) nontransaction reserveable liabilities such
as nonpersonal CDs, Eurocurrency liabilities etc require 0 legal reserves).

First National Bank’s net transaction deposit averaged $100 million over the 14-day
reserve computation period while its nontransaction reserveable liabilities had a daily
average of $200 million over the same period. It held a daily total legal reserves
averaging $7.00 million and daily average of $5 million in vault cash over the same
computation period. Calculate
(a) Daily average total required legal reserves (RR).
(b) Excess reserve.
(c) Daily average required legal reserves held to Fed (Central Bank).

(a) Daily average total required legal reserves = RR = $0.0×$9.3 + 0.03×($43.9 – $9.3)
+ 0.10×($100 - $43.9) = $6.648
million.
(b) Excess reserve = ER = ($7.00 – $6.648) = $0.352 million.
(c) Daily average required legal reserves held to Fed = RR – Vault cash = ($6.648 - $5)
= $1.648 million

Penalty for a Reserve Deficit: Any deficit above 4% may be assessed an interest penalty
equal to the Federal Reserve’s 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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Clearing Balances: Many depository institutions also hold a clearing balance with the
Fed to cover any checks or other debit items drawn against them. In fact, any financial
institution using the Federal Reserve check clearing system has to maintain a minimum
balance with the Federal Reserve. When they fall more than 2% below the minimum
balance required, they must provide additional funds to bring the balance up to the
promised level. The amount is determined by its estimated check clearing needs and its
recent record of overdrafts. The clearing balance can be a benefit because the institution
earns credits from holding this balance with the Fed and this credit can be used to pay the
fees the Fed charges for services. For example, suppose a bank had a clearing balance
averaging $1 million during a particular 2-week maintenance period and Federal funds
interest rate over this period averaged 5.5 percent. Then it would earn a Federal Reserve
credit of
Average clearing balance × Annualized Fed funds rate × 14 days/360 days
= $1,000,000 × 0.055 × 0.0389 = $2,138.89.
This bank would apply up to $2,138.89 to offset any fees charged for the bank for its use
of Federal reserve services.

Factors Influencing the Money Position

A depository institution’s money position is influenced by a long list of factors, some of
which are given in the following table. Among the most important are:
• the volume checks and other drafts clear each day
• the amount of currency and coin shipments back and forth each bank and the
central bank’s vault
• purchases and sales of government securities
• the borrowing and lending in the Federal funds (interbank) market.
Some of these factors are largely controllable by management, while others are
essentially noncontrollable, and management needs to anticipate and reach quickly to
them.
In recent years the volume of legal reserves held at the Fed by depository institutions
operating in the US has declined sharply. This decline is largely due to the development
of sweep accounts. Under sweep accounts bankers can shift their customers’ deposited
funds out of low-yielding accounts that carry reserve requirements (currently checkable
or transaction accounts), usually overnight, into repurchase agreements, shares of money
market funds, and saving accounts (not currently bearing reserve requirements). That is,
Sweep account is a Contractual Account Between Bank and Customer that
Permits the Bank to Move Funds Out of a Customer’s low-yielding accounts that
carry reserve requirements (Checking Account or transaction accounts), usually
Overnight, into repurchase agreements, shares in money market funds, and savings
accounts (not currently bearing reserve requirements) in Order to Generate Higher
Returns for the Customer and Lower Reserve Requirements for the Bank.

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Two types of sweep accounts are offered:
1. Retail sweeps which involves checking and saving accounts of individuals and
families.
2. Business sweeps where commercial checkable deposit balances are changed
overnight into commercial saving deposits or moved to interest-bearing
investments and then quickly returned.
Factors Influencing the Money Position

The key goal of money position management is to keep legal reserves at the required
level, with no excess reserves (ER = 0) and no reserve deficit large enough to incur
penalty. If ER > 0, it will sell federal funds to other depositories short of legal reserves, or
if the excess appears to be longer lasting, purchase securities or make new loans. If legal
reserve deficit, it would do the opposite, that is, purchase federal funds or borrow from
Fed. If the deficit appears to be large and long lasting, it may sell some of its securities
and cut back on its lending.
Table 11 – 6 illustrates how a bank, for example, can keep track of its reserve position on
daily basis.

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Use of Federal Funds Market
When a money position manager has a reserve deficit to cover in a hurry, it can elect to
borrow heavily in the Federal Funds Market. It is usually one of the cheapest places to
borrow reserve, but also frequently volatile. The effective interest rate on federal funds
changes minute by minute so money position managers must stay abreast of both the
level and upward or downward movements in the effective daily fed funds rate. They
must be aware of the fact that the Fed sets a target Fed funds rate and intervenes
periodically to move the current funds rate closer to the Fed’s target rate.

Other Options besides Fed Funds: These include

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

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11 – 7 Factors to Consider in Choosing Among the Different Sources of Reserves
In choosing which source of reserves to draw upon to cover a legal reserve deficit, money
position manager must carefully consider several aspects of their institution’s need for
liquid funds:
1. Immediacy of need. If a reserve deficit comes due within minutes or hours, managers
will normally use federal funds market for an overnight loan or borrow from Fed’s
discount window. For nonimmediate reserve, they can use other sources.
2. Duration of need. If a reserve deficit is expected to last only for few hours, managers
preferred choice is to use federal funds market for an overnight loan or borrow from
Fed’s discount window. For longer lasting shortages, they can use other sources.
3. Access to the market for liquid funds. Liquidity managers must restrict their range of
choices to those their institution can access quickly.
4. Relative Costs and Risks of Alternatives. Other things being equal, the liquidity
manager will draw on the cheapest source of reliable funds, maintaining constant
contact with money and capital markets to be aware of how interest rates and credit
conditions are changing.
5. Interest Rate Outlook. The liquidity manager wants to draw upon those funds sources
whose interest rates are expected to be lowest.
6. Outlook for Central Bank Monetary Policy. Outlook for Central Bank Monetary
Policy affects the market interest rate. For example, a more restrictive monetary
policy implies higher borrowing costs and reduced credit availability for liquidity
managers.
7. Rules and Regulations Applicable for Liquidity Sources. Most sources of liquidity
cannot be used indiscriminately, the user must conform to the rules.
The liquidity manager must carefully weigh each of these factors in order to make a
rational choice among alternative sources of reserves.

Problem
First National Bank finds that its net transactions deposits average $140 million over the
latest reserve computation period. Given the reserve requirement ratios imposed by the
Federal Reserve as given in the textbook, what is the bank's total required legal reserve?

Total Required Legal = 0.03 * [First $42.1 million of Transaction Deposits] +

Reserves 0.10 *
[Amount of Transaction Deposits in Excess of $42.1
million]
= .03 * $42.1 + .10 * ($140 - $42.1)
= $1.263 million + $9.79 million
= $11.053 million

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Problem
A U.S. savings bank has a daily average reserve balance at the Federal Reserve Bank in
its district of $25 million during the latest reserve maintenance period. Its vault cash
holdings have averaged $1 million and the bank's total transaction deposits (net of
interbank deposits and cash items in collection) averaged $200 million daily over the
latest reserve maintenance period. Does this depository institution have a legal reserve
deficiency? How would you recommend that its management responds to the current
situation?

The bank's total required legal reserves must be:

Required Legal Reserves = 0.03 x [First $42.1 million of Transactions Deposits] +

0.10
[Transactions Deposits Over $42.1 million]
= $1.263 million + $15.79 million = $17.053 million

The average vault cash of $1 million plus the $25 million at the district Reserve Bank
indicates total maintained reserves of $26 million, meaning the bank is over required
reserves by $8,947,000. Management will have to plan how to invest this excess reserve
taking into account any anticipated drain on funds in the near future and taking into
account any reserve deficit in the previous period.

Problem
Suppose a bank maintains an average clearing balance of $5 million during a period in
which the Federal funds rate averages 6 percent. How much would this bank have
available in credits at the Federal Reserve Bank in its district to help offset the charges
assessed against the bank for using Federal Reserve services?

Reserve Credit = Avg. Clearing Balance x Annualized Fed Funds Rate x 14 days/360
days
= $5,000,000 x .06 x 14/360 = $11,666.67

Concept Checks

10-1. What are the principal sources of liquidity demand for a bank or other financial
firm?

The most pressing demands for liquidity arise principally from customers withdrawing
money from their deposits and credit requests.

10-2. What are the principal sources from which the supply of liquidity comes?

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Supplies of funds stem principally from incoming deposits, sales of bank assets,
particularly money market securities, and repayments of outstanding loans.

10-3. Suppose a bank faces the following cash inflows and outflows (in millions of
dollars) during the coming week:

Cash Inflows Cash Outflows

Customer Loan $108 Deposit Withdrawals $33
Repayments
Sales of Bank Assets 18 Operating Expenses 51
New Deposits 670 New Loan Requests 294
Money-Market Borrowings 43 Repayment of Previous 23
Borrowings
Nondeposit Service Fees 27 Dividend to Stockholders 14
0

Total Cash Inflows $866 Total Cash Outflows $541

Net Liquidity
Position Total Cash Total Cash
Projected for = Inflows - Outflows
the Coming
Week

= $866 million - $541 million

= + $325 million

10-4. When is a bank or other financial institution adequately liquid?

A financial institution is adequately liquid if it has adequate cash available precisely

when cash is needed at a reasonable cost. Management can monitor the cash position
over time and monitor as well what is happening to its cost of funds. One indicator of the
adequacy of the liquidity position is its cost - a rising interest cost may reflect greater
perceived risk for the borrowing bank as viewed by capital-market investors.

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10-5. Why do banks and many of their closest financial service competitors face
significant liquidity management problems?

Financial institutions are prone to liquidity management problems due to:

(1) their relatively high proportion of short-term deposits and relatively long-term
financial assets:

(2) the sensitivity of their assets and liabilities to interest-rate movements; and

(3) their central role in the payments process.

10-6. What are the principal differences among asset management, liability
management, and balanced liquidity management?

Asset management is a strategy for meeting liquidity needs, used mainly by smaller
banks, in which liquid funds are stored in readily marketable assets that can be quickly
converted into cash as needed. Liability management involves borrowing enough
immediately spendable funds to cover demands for liquidity made against a bank.
Balanced liquidity management calls for using both asset management and liability
management to cover a bank's liquidity needs.

10-7. What guidelines should management keep in mind when it manages a bank or
other financial firm’s liquidity position?

It is important for a liquidity manager to: (a) keep track of the activities of other
departments within the bank; (b) know in advance the planned activities of the bank's
largest credit and deposit customers; (c) set priorities and objectives in liquidity
management; and (d) react quickly to liquidity deficits and liquidity surpluses.

Liquidity managers must know what other departments within the institution are doing
because their activities affect the liquidity position and liquidity management decisions.
The liquidity manager can make better decisions to profitably invest surplus liquid funds
or avoid costly, last-minute borrowings if he or she knows what the bank's principal
depositors and creditors will do in advance. By setting priorities and objectives the
liquidity manager has a better chance to make sound decisions plus an ability to act
quickly to profitably invest surpluses in order to gain maximum income or avoid costly
deficits and prolonged borrowings.

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10-8. How does the Sources and Uses of Funds approach help a manager estimate a
financial institution’s need for liquidity?

The sources-and-uses-of-funds approach estimates future deposit inflows and estimated

outflows of funds associated with expected loan demand and calculates the net difference
between these items in each planning period.

10-9. A bank faces the following estimated deposit and loan figures for each of the next
six months: (all figures in millions)

Estimated Total Estimated Total Loans

Deposits
$112 $87
132 95
121 102
147 113
151 101
139 124

Estimated Liquidity
Change in Deposits Change in Loans Deficit or Surplus

$ --- $ --- $ ---

+20 +8 +12
-11 +7 -18
+26 +11 +15
+4 -12 +16
-12 +23 -35

Clearly, the bank has projected liquidity surpluses (which should be profitably invested)
for three of the next four months, but a deficit is estimated for the second and last month
which will have to be covered through borrowings and possibly through the sale of liquid
assets.

10-10. What steps are needed to carry out the structure of funds approach to
liquidity management?

In the first step, the institution's deposits and other funds sources are divided into
categories based on their estimated probability of being withdrawn and, therefore, lost to
the bank. Second, the liquidity manager must set aside liquid funds according to some
desired operating rules for "hot money" liabilities, vulnerable funds, and stable funds.

27
10-11. Suppose that a thrift institution’s liquidity division estimates that it holds $19
million in hot money deposits and other IOUs against which it will hold an 80 percent
liquidity reserve, $54 million in vulnerable funds against which it plans to hold a 25
percent reserve, and $112 million in stable or core funds against which it will hold a 5
percent liquidity reserve. The thrift expects its loans to grow 8 percent annually; its loans
currently stand at $117 million, but have recently reached $132 million. If reserve
requirements on liabilities currently stand at 3 percent, what is this depository
institution’s total liquidity requirement?

Total Liquidity
Requirement = 0.80 ($19 million - 0.03 x $19 million)

+ 0.25 ($54 million - 0.03 x $54 million)

+ 0.05 ($112 million - 0.03 x $112 million)

+ ($132 million +O.08 x $132 million - $117 million)

= $58.83 million

10-12. What is the liquidity indicator approach to liquidity management?

The liquidity indicator approach uses tell-tale financial ratios (e.g., total loans/total assets
or cash assets/total assets) whose changes over time may reflect the changing liquidity
position of the financial institution. The ratios are used to estimate liquidity needs and to
monitor changes in the liquidity position.

10-13. First National Bank has the balance sheet entries listed below. How many
liquidity indicators can be calculated from these figures?

Assets Liabilities

Cash Deposits held at Federal Fund Purchased $ 62

other Banks $ 633
U.S. Government securities $ 185 Demand Deposits $ 988
Net Loans and Losses $3,502 Time Deposits $2,627
Federal Funds Sold $ 48
Total Assets $4,496

The liquidity indicators that we can construct from the foregoing figures include:

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 Cash Position Indicator:

Cash and Deposits Due from Other = $633 = 14.08 percent

Banks
Total Assets $4496

Net Federal Funds Position:

(Federal Funds Sold – Federal Funds = ($48 - $62) = - 0.31 percent

Purchases)
Total Assets $4496

Capacity Ratio:

Net Loans and Leases = $3,50 = 77.89 percent

2
Total Assets $4496

Deposit Composition Ratio:

Demand Deposits = $988 = 37.61 percent

Time Deposits $2,62
7

Liquid Securities Indicator:

U.S. Government = $385 = 4.16 percent

Securities
Total Assets $4,496

10-18. First National Bank finds that its net transactions deposits average $140 million
over the latest reserve computation period. Given the reserve requirement ratios imposed
by the Federal Reserve as given in the textbook, what is the bank's total required legal
reserve?

Total Required Legal Reserves
= 0.03 * [First $42.1 million of Transaction Deposits] + 0.10 *
[Amount of Transaction Deposits in Excess of $42.1 million]
= .03 * $42.1 + .10 * ($140 - $42.1)
= $1.263 million + $9.79 million
= $11.053 million

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10-19. A U.S. savings bank has a daily average reserve balance at the Federal Reserve
Bank in its district of $25 million during the latest reserve maintenance period. Its vault
cash holdings have averaged $1 million and the bank's total transaction deposits (net of
interbank deposits and cash items in collection) averaged $200 million daily over the
latest reserve maintenance period. Does this depository institution have a legal reserve
deficiency? How would you recommend that its management responds to the current
situation?

The bank's total required legal reserves must be:

Required Legal Reserves = 0.03 x [First $42.1 million of Transactions Deposits] + 0.10
[Transactions Deposits Over $42.1 million]
= $1.263 million + $15.79 million = $17.053 million

The average vault cash of $1 million plus the $25 million at the district Reserve Bank
indicates total maintained reserves of $26 million, meaning the bank is over required
reserves by $8,947,000. Management will have to plan how to invest this excess reserve
taking into account any anticipated drain on funds in the near future and taking into
account any reserve deficit in the previous period.

10-20. What factors should a money position manager consider in meeting a

deficit in a depositary institution’s legal reserve account?

Several factors must be taken into account by the liquidity manager, including current
and expected future levels of interest rates, projected changes in monetary policy, the
bank's borrowing capacity and current holdings of liquid assets, the bank's forecast of
future deposit growth and loan demand, the expected size and duration of any liquidity
deficits or surpluses, and his or her knowledge of the future plans of the bank's largest
depositors and borrowers with credit lines.

10-21. What are clearing balances? Of what benefit can clearing balances be to a bank or
other depository that uses the Federal Reserve System’s check-clearing network?

Any financial institution using the Federal Reserve check clearing system has to maintain
a minimum balance with the Federal Reserve. The amount is determined by its estimated
check clearing needs and its recent record of overdrafts. The clearing balance can be a
benefit because the institution earns credits from holding this balance with the Fed and
this credit can be used to pay the fees the Fed charges for services.

10-22. Suppose a bank maintains an average clearing balance of $5 million during a

period in which the Federal funds rate averages 6 percent. How much would this bank
have available in credits at the Federal Reserve Bank in its district to help offset the
charges assessed against the bank for using Federal Reserve services?

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Reserve Credit = Avg. Clearing Balance x Annualized Fed Funds Rate x 14 days/360
days
= $5,000,000 x .06 x 14/360 = $11,666.67

10-23. What are sweeps accounts? Why have they led to a significant decline in the total
legal reserves held at the Federal Reserve banks by depository institutions operating in
the United States?

A sweeps account is a service provided by banks where they sweep money out of
accounts that carry reserve requirements (such as demand deposits and other checking
accounts) into savings accounts which do not carry reserve requirements overnight. This
service lowers the bank’s overall cost of funds while still allowing the customer access to
their deposits for payments. These sweep arrangements account for nearly $200 billion
in deposit balances today and therefore have significantly reduced the total reserve
requirements of banks.

31