Bank Liquidity

Dilemma: Profitability vs. Safety

One way for a bank to increase expected profits is to
take on more risk. However, this can jeopardize
bank safety.

For a bank to survive, it must balance the

demands of three constituencies:
shareholders
depositors
regulators

Each with their own interest in profitability and

safety.

2
 Solvency and Liquidity
Solvency: Maintaining the momentum of a going
concern, attracting customers and financing.
A firm is insolvent when the value of its liabilities
exceeds the value of its assets.
Banks have relatively low capital/asset ratios but
generally high-quality assets.

Liquidity: the ability to fund deposit withdrawals,

loan requests, and other promised disbursements
when due.
A bank can be profitable and still fail because of
illiquidity.

3
 Conflicting Demands
A bank must balance profitability, liquidity, and
solvency.

Bank failure can result from excessive losses on

loans or securities -- from over-aggressive profit
seeking. But a bank that only invests in high-quality
assets may not be profitable.

Failure can also occur if a bank cannot meet

liquidity demands. If assets are profitable but
illiquid, the bank also has a problem.

Bank insolvency often leads to bank illiquidity.

4
 Liquidity Management
Banks rely on both asset sources of liquidity
and liability sources of liquidity to meet the
demands for liquidity.

The demands for liquidity include

accommodating deposit withdrawals,
paying other liabilities as they come due,
and accommodating loan requests.

5
 Asset Management

Primary Reserves are noninterest bearing, extremely

liquid bank assets
Secondary Reserves are high-quality, short-term,
marketable earning assets
Bank Loans are made after absolute liquidity needs
are met
After loan demand is satisfied, funds are allocated to
Income Investments that provide income, reasonable
safety, and some liquidity, if needed

6
 The Bank Balance Sheet

The Balance Sheet is a list of a bank’s

assets and liabilities
Total assets = total liabilities + capital
 The Bank Balance Sheet

A bank’s balance sheet lists sources of

bank funds (liabilities) and uses to which
they are put (assets)
Banks invest these liabilities (sources) into
assets (uses) in order to create value for
their capital providers
 The Bank Balance Sheet
Lowest cost
source of
funds--
payable on
demand
Pay no
interest
Deposit
Secondary
with no
reserves
check
writing
Discount loans
74% of Fed Funds,
Assets
Corporate Loans

Bank Equity = Assets - Liabilities,

listed as Liab because Bank owes this
to owners. Also includes Loan
Flow of funds (tab down to commercial banks)
http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf
Loss Reserves
 Basics of Banking

▪ T-account Analysis:
─ Deposit of $100 cash into First National Bank
 Basics of Banking

▪ Deposit of $100 check

▪ Conclusion: When bank receives deposits,

reserves  by equal amount; when bank
loses deposits, reserves  by equal amount
 Basics of Banking– Required Reserves
▪ Deposit of $100 cash into First National Bank
assuming Required Reserve ratio of 10%

─ $10 of the deposit must remain in reserves to meet federal

regulations (10% reserve req.).
─ Now, the bank is free to work with the $90 in its asset
transformation function. In this case, the bank loans the $90
to its customers.
 Basics of Banking

▪ Loaning out excess reserves

 Principles of Bank Management
Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million
Assets Liabilities
Reserves $20 million Deposits $100 million
Loans $80 million Bank Capital $10 million
Securities $10 million Deposit outflow
- 10 m Deposit outflow of $10 million - 10 m
Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $80 million Bank Capital $10 million
Securities $10 million

• With 10% reserve requirement, bank still has excess reserves of $1

million: no changes needed in balance sheet
 Liquidity Management

No excess reserves
Assets Liabilities
Reserves $10 million Deposits $100 million
Loans $90 million Bank Capital $10 million
Securities - 10 m $10 million - 10 m
Deposit outflow of $10 million
Assets Liabilities
Reserves $0 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities $10 million
▪ With 10% reserve requirement, bank has $9 million reserve
shortfall
 Liquidity Management

1. Borrow from other banks or corporations

Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Borrowings $9 million +9m

Securities $10 million Bank Capital $10 million

2. Sell securities
Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities - 9m $1 million

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 Liquidity Management

3. Borrow from Fed

Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans $90 million Discount Loans $9 million +9m

Securities $10 million Bank Capital $10 million

4. Call in or sell off loans

Assets Liabilities
Reserves +9m $9 million Deposits $90 million
Loans - 9m $81 million Bank Capital $10 million
Securities $10 million

▪ Conclusion: Excess reserves are insurance against above 4

costs from deposit outflows
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