Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

CHAPTER 11

LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES

Goal of This Chapter: The purpose of this chapter is to explore the reasons why financial
institutions often face heavy demands for immediately spendable funds (liquidity) and learn
about the methods they can use to prepare for meeting their cash needs.
Key Topics in This Chapter

 Sources of Demand for and Supply of Liquidity

 Why Financial Firms Have Liquidity Problems
 Liquidity Management Strategies
 Estimating Liquidity Needs
 The Impact of Market Discipline
 Legal Reserves and Money Management

Chapter Outline

I. Introduction: Meaning of Liquidity

II. The Demand for and Supply of Liquidity
A. Sources of Liquidity Demands
B. Sources of Liquidity Supplies
C. Net Liquidity Position
1. Liquidity Surplus
2. Liquidity Deficit
D. Liquidity Time Dimension
1. Immediate Liquidity
2. Longer-term Liquidity
E. Liquidity Management Problems
1. Rarely are Demands for Liquidity Equal to the Supply of Liquidity
2. There is a Trade-off Between Liquidity and Profitability
F. Risks Involved I n Management of Liquidity
1. Interest Rate Risk
2. Availability Risk
III. Why Financial Firms Often Face Significant Liquidity Problems
A. Maturity Mismatches
B. Sensitivity to Changes in Market Interest Rates
C. Meeting Demand for Liquidity and Public Confidence
IV. Strategies for Liquidity Managers
A. Asset Liquidity Management (or Asset Conversion) Strategies
B. Borrowed Liquidity (Liability) Management Strategies
C. Balanced Liquidity Management Strategies
D. Guidelines for Liquidity Managers
V. Estimating Liquidity Needs

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

A. The Sources and Uses of Funds Approach

1. Trend Component
2. Seasonal Component
3. Cyclical Component
B. The Structure of Funds Approach
C. Liquidity Indicator Approach (Ratios)
1. Cash Position Indicator
2. Liquid Securities Indicator
3. Net Federal Funds And Repurchase Agreements Position
4. Capacity Ratio
5. Pledged Securities Ratio
6. Hot Money Ratio
7. Deposit Brokerage Index
8. Core Deposit Ratio
9. Deposit Composition Ratio
10. Loan Commitments Ratio
D. The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace
1. Public Confidence
2. Stock Price Behavior
3. Risk Premiums on CDs and Other Borrowings
4. Loss Sales of Assets
5. Meeting Commitments to Credit Customers
6. Borrowings from the Central Bank
VI. Legal Reserves and Money Position Management
A. The Money Position Manager
B. Legal Reserves
C. Regulations on Calculating Legal Reserve Requirements
1. Reserve Computation
2. Reserve Maintenance
3. Reserve Requirements
4. Calculating Required Reserves
5. Clearing Balances
D. Factors Influencing the Money Position
1. Controllable Factors
2. Noncontrollable Factors
3. An Example
4. Use of the Federal Funds Market
5. Other Options besides Fed Funds
6. Bank Size and Borrowing and Lending Reserves for the Money Position
7. Overdraft Penalties
VII. Factors in Choosing among the Different Sources of Reserves
A. Immediacy of need
B. Duration of need
C. Access to the market for liquid funds
D. Relative costs and risks of alternative sources of funds
E. The interest rate outlook

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F. Outlook for central bank monetary policy

G. Rules and regulations applicable to a liquidity source
VIII. Central Bank Reserve Requirements around the Globe
IX. Summary of the Chapter

Concept Checks

11-1. What are the principal sources of liquidity demand for a financial firm?

The most pressing demands for liquidity arise principally from customers withdrawing money
from their deposit accounts and credit requests from customers the institution wishes to keep,
either in the form of new loan requests or drawings upon existing credit lines. However,
demands for liquidity can also come from paying off previous borrowings, operating expenses.
and payment of income taxes. The demand may also arise from payment of cash dividends to
stockholders.

11-2. What are the principal sources from which the supply of liquidity comes?

Supplies of funds stem principally from incoming deposits, sales of assets, particularly
marketable securities, and repayments of outstanding loans. Liquidity also comes from the sale
of nondeposit services and borrowings from the money market.

11-3. 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. What is this bank’s projected net liquidity position for the coming week?

The bank’s liquidity position for the coming week is as follows:

(In millions of dollars)
Cash Inflows Cash Outflows
Customer Loan Repayments $108 Deposit Withdrawals $33
Sales of Bank Assets 18 Operating Expenses 51
New Deposits 670 New Loan Requests 294
Money-Market Borrowings 43 Repayment of Previous Borrowings 23
Nondeposit Service Fees 27 Dividend to Stockholders 140

Total Cash Inflows $866 Total Cash Outflows $541

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

= $866 million − $541 million

= +$325 million

11-4. When is a 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 also
monitor what is happening to its cost of funds. One indicator of the adequacy of the liquidity
position is its cost; a rising interest cost on borrowed funds, or transaction costs of time and
money, and opportunity cost in the form of future earnings may reflect greater perceived risk for
the borrowing bank as viewed by capital-market investors.

11-5. Why do financial firms face significant liquidity management problems?

Financial institutions are prone to liquidity management problems due to:

(1) A maturity mismatch situation in which most depository institutions hold an unusually high
proportion of liabilities subject to immediate payment, especially demand (checkable) deposits
and money market borrowings. Whereas, they use these funds to make long-term credit available
to their borrowing customers. The institution faces an imbalance between the maturity dates
attached to their assets and the maturity dates of their liabilities.

(2) The sensitivity of changes to their assets and liabilities values towards market interest-rate
movements. When interest rates rise, some customers will withdraw their funds in search of
higher returns elsewhere. Many loan customers may postpone new loan requests or speed up
their drawings on those credit lines that carry lower interest rates. Thus, changing market interest
rates affect both customer demand for deposits and customer demand for loans, each of which
has a potent impact on a depository institution’s liquidity position.

(3) Their central role in the payments process is that financial firms must give high priority to
meeting demands for liquidity. To fail in this area may severely damage public confidence in the
institution.

11-6. What are the principal differences among asset liquidity management, liability
management, and balanced liquidity management?

Asset liquidity management is a strategy for meeting liquidity needs, used mainly by smaller
financial institutions, that find it a less risky approach to liquidity management. In this strategy,

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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 all
anticipated demands for liquidity. Borrowing liquidity is the most risky approach to solving
liquidity problems because of the volatility of interest rates and the rapidity with which the
availability of credit can change, although it carries the highest expected return along with the
risk taken.

Balanced liquidity management calls for using both asset liquidity management and liability
management to cover a bank's liquidity needs. Under a balanced liquidity management strategy,
some of the expected demands for liquidity are stored in assets, while other anticipated liquidity
needs are backstopped by advance arrangements for lines of credit from potential suppliers of
funds.

11-7. What guidelines should management keep in mind when it manages a financial firm’s
liquidity position?

It is important for a liquidity manager to: (a) keep track of the activities of all departments within
the bank which use or supply funds; (b) know in advance the activities and plans of the bank's
largest credit and funds-supplying customers; (c) set clear priorities and objectives in liquidity
management; and (d) analyze on a continuing basis so as to react quickly to liquidity deficits and
liquidity surpluses.

Liquidity managers must know what all 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 clear priorities and objectives, the liquidity manager has a better chance to
make sound decisions plus an ability to act quickly to invest surpluses in order to gain maximum
income or avoid costly deficits and prolonged borrowings.

11-8. 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.

When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of
the difference between sources and uses of funds. When sources of liquidity (for example,
increasing deposits or decreasing loans) exceed uses of liquidity (for example, decreasing
deposits or increasing loans) then the financial firm will have a positive liquidity gap (surplus).
Its surplus liquid funds must be quickly invested in earning assets until they are needed to cover
future cash needs. On the other hand, when uses exceed sources, a financial institution faces a

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negative liquidity gap (deficit). It now must raise funds from the cheapest and most timely
sources available.

Management can now begin planning, first evaluating the bank’s stock of liquid assets to see
which assets are likely to be available and then determining if adequate sources of borrowed
funds are likely to be available.

11-9. Suppose that a bank estimates its total deposits for the next six months in millions of
dollars to be, respectively, $112, $132, $121, $147, $151, and $139, while its loans (also in
millions of dollars) will total an estimated $87, $95, $102, $113, $101, and $124, respectively,
over the same six months. Under the sources and uses of funds approach, when does this bank
face liquidity deficits, if any?

Estimated
Estimated Estimated Change in Change in Liquidity Deficit
Total Deposits Total Loans Deposit Loans or Surplus
$112 $87 $— $— $—
132 95 +20 +8 +12
121 102 −11 +7 −18
147 113 +26 +11 +15
151 101 +4 −12 +16
139 124 −12 +23 −35

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

11-10. 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 upon their estimated probability of being withdrawn. We can divide a bank’s deposit and
nondeposit liabilities into three categories. (1) “Hot money” liabilities refer to 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 refer to customer deposits of which a substantial
portion will probably be withdrawn sometime during the current time period. (3) Stable funds are
those funds that the management considers unlikely to be removed.
In the second step, the liquidity manager must set aside liquid funds according to some desired
operating rules This liquidity reserve might consist of holdings of immediately spendable
deposits in correspondent institutions plus investments in Treasury bills and repurchase
agreements where the committed funds can be recovered in a matter of minutes or hours.

11-11. 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 liquidity reserve, and
$112 million in stable or core funds against which it will hold a 5 percent liquidity reserve. The

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thrift expects its loans to grow 8 percent annually; its loans currently total $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 × $19 million)

+ 0.25 ($54 million − 0.03 × $54 million)

+ 0.05 ($112 million − 0.03 × $112 million)

+ $132 million × 0.08 + ($132 million − $117 million)

= $58.831 million

11-12. What is the liquidity indicator approach to liquidity management?

The liquidity indicator approach uses financial ratios whose changes over time may reflect the
changing liquidity position of the financial institution. Some of the ratios include cash position
indicator, liquid securities indicator, net federal funds and repurchase agreements position,
capacity ratio, pledged securities ratio, hot money ratio, deposit brokerage index and core deposit
ratio, deposit composition ratio and loan commitments ratio. These ratios are used to estimate
liquidity needs and to monitor changes in the liquidity position.

11-13. First National Bank posts the following balance sheet entries on today’s date: Net loans
and leases, $3,502 million; cash and deposits held at other banks, $633 million; Federal funds
sold, $48 million; U.S. government securities, $185 million; Federal funds purchased, $62
million; demand deposits, $988 million; time deposits, $2,627 million; and total assets, $4,446
million. How many liquidity indicators can you calculate from these figures?

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

Cash Position Indicator:

Net Federal Funds Position:

Credit Capacity Ratio:

Deposit Composition Ratio:

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Liquid Securities Indicator:

11-14. How can the discipline of the marketplace be used as a guide for making liquidity
management decisions?

No financial institution can tell for sure if it has sufficient liquidity until it has passed the
market's test. Specifically, management should look at these signals: public confidence, stock
price behavior, risk premiums on CDs and other borrowings, loss sales of assets, meeting
commitments to credit customers, and borrowings from the Federal Reserve banks. 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 needed.

11-15. What is money position management?

Money position management is the management of a financial institution’s liquidity position that
requires quick decisions which may have long-run consequences on profitability. Most large
depository institutions have designated an officer of the firm as money position manager. A
money position manager is responsible for ensuring that the institution maintains an adequate
level of legal reserves. Legal reserve requirements apply to all qualified depository institutions,
including commercial and savings banks, savings and loan associations, credit unions, and
agencies and branches of foreign banks that offer transaction deposits or nonpersonal (business)
time deposits or borrow through Eurocurrency liabilities.

11-16. What is the principal goal of money position management?

The money position management’s goal is to ensure that the bank has sufficient legal reserves to
meet its reserve requirements at a particular time, as imposed by the law and central bank
regulation. For example, in the United States a qualified depository institution must hold the
required level of legal reserves in the form of vault cash and, if this is not sufficient, in the form
of deposits held in a reserve account at the Federal Reserve bank in the region. Smaller
depository institutions and banks, who are not members of the Federal Reserve System, may be
granted permission to hold their legal reserve deposits with a Fed-approved institution.
The management also makes sure that it holds not more than the minimum legal requirement
because excess legal reserves yield no income for the bank.

11-17. Exactly how is a depository institution’s legal reserve requirement determined?

Each reservable liability item is multiplied by the stipulated reserve requirement percentage set
by the Federal Reserve Board to derive the bank's total legal reserve requirements. Thus, total
required legal reserves is computed as follows:

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

Reserve requirement on transaction deposits × Daily average amount of net transaction deposits
over the computation period + Reserve requirement on nontransaction reservable liabilities ×
Daily average amount of nontransaction reservable liabilities over the computation period
Currently nontransaction liabilities have a reserve requirement of zero.

Once a depository institution determines its required reserve amount, it compares that figure to
its actual daily average holdings of legal reserves. If total legal reserves held are greater than
required reserves, the depository institution has excess reserves. Normally management of the
financial firm will move quickly to invest any excess reserves to earn additional income. On the
other hand, if it is determined that the institution has a reserve deficit, law and regulation
normally require the institution to cover this deficit by acquiring additional legal reserves

11-18. First National Bank finds that its net transaction deposits average $140 million over the
latest reserve computation period. Using 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 $58.8 − $910.7 million] + 0.10 × [Amount in
Reserves excess of $58.8 million]
= 0.03 × $48.1 + 0.10 × ($140 − $58.8)
= $1.443 million + $8.12 million
= $9.563 million

11-19. 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
averaged $1 million and the savings 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 currently have a legal reserve deficiency? How would
you recommend that its management respond to the current situation?

The bank's total required legal reserves must be:

Required Legal Reserves = 0.03 × [First $58.8 – $10.7 million] + 0.10 × [Amount in excess of
$58.8 million]
= 0.03 × $48.1 + 0.10 × ($200 - $58.8)
= $1.443 million + $14.120 million = $15.563 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 has excess required reserves by
$10.437 million. 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.

11-20. What factors should a money position manager consider in meeting a deficit in a
depository institution’s legal reserve account?

There are various factors that can help increase the legal reserves of a depository institution.

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Some such factors are receiving more deposited checks in the institutions favor than checks
drawn against it, receiving deposits made by the U.S. Treasury into a tax and loan account held
at the bank, receiving credit from the Federal Reserve bank for checks previously sent for
collection, and receiving credit from cash letters sent to the Fed, listing drafts received by the
bank can help the depository institution in meeting a deficit. However, these are essentially
noncontrollable, and management needs to anticipate and react quickly to them.

Some of the controllable factors for increasing the legal reserves are selling securities, receiving
interest payments on securities, borrowing reserves from the Federal Reserve Bank, purchasing
Federal funds from other banks, selling securities under a repurchase agreement, and selling new
CDs, Eurocurrency deposits, or other deposits to customers.

11-21. What are clearing balances? Of what benefit can clearing balances be to a depository that
uses the Federal Reserve System’s check-clearing network?

Depository institutions, along with holding a legal reserve account, also hold a clearing balance
with the Fed to cover any checks or other debit items drawn against them. Any institution using
the Federal Reserve check clearing system has to maintain a minimum balance with the Federal
Reserve. The amount is determined by an agreement between the institution and its district
Federal Reserve bank. 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.

11-22. 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?

Reserve Credit = Avg. Clearing Balance x Annualized Fed Funds Rate x 14 days/360 days
= $5,000,000 × 0.06 × 14/360 = $11,666.67

11-23. What are sweep 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
repurchase agreements, shares in money market funds, and 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 $500 billion in deposit balances today and therefore have significantly reduced the
total reserve requirements of banks.

11-24. What impact has recent financial reform legislation had on raising short-term cash?

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The recent passage of FINREG—the Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2009 have increased the raising of short-term cash. This extensive legislation removed the
long-standing prohibition against banks paying interest on commercial checking accounts which
had stood for about 75 years. Recent research has suggested quite that banks benefit by granting
interest on business deposits. Now bankers can compete for corporate deposits and more easily
attract capital, which was going abroad more often than not, and bring cash accounts back to
their home offices inside the United States.

Problems

11-1. Ocean View State Bank estimates that over the next 24 hours the following cash inflows
and outflows will occur (all figures in millions of dollars):

Deposit withdrawals $100 Sales of bank assets $ 40

Deposit inflows 95 Stockholder dividend payments 150
Revenues from sale of nondeposit
Scheduled loan repayments 90 services 95
Acceptable loan requests 60 Repayments of bank borrowings 60
Borrowings from the money
market 80 Operating expenses 50

What is this bank’s projected net liquidity position in the next 24 hours? From what sources can
the bank cover its liquidity needs?

Deposit withdrawals $100 −

Deposit inflows $95 +
Scheduled loan repayments $90 +
Acceptable loan requests $60 −
Borrowings from the money market $80 +
Sales of bank assets $40 +
Stockholder dividend payments $150 −
Revenues from sale of nondeposit
services $95 +
Repayment of bank borrowings $60 −
Operating expenses $50 −

= [$95 + $90 + $80 + $40 + $95] − [$100 + $60 + $150 + $60 + $50]
= 400 − 420
= −$20 million.

Faced with an expected liquidity deficit, Ocean View State Bank could arrange to increase its
money market borrowings from other institutions or sell some of its assets or do some of both.

11-2. Mountain Top Savings is projecting a net liquidity deficit of $10 million next week
partially as a result of expected quality loan demand of $32 million, necessary repayments of
previous borrowings of $15 million, planned stockholder dividend payments of $10 million,

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expected deposit inflows of $26 million, revenues from nondeposit service sales of $18 million,
scheduled repayments of previously made customer loans of $23 million, asset sales of $10
million, other operating expenses of $15 million, and money market borrowings of $15 million.
How much must Mountain Top’s expected deposit withdrawals be for the coming week?

Supply of Liquidity Flowing into the Mountain Top Savings

Expected deposit inflows $26
Revenues from nondeposit service sales 18
Scheduled repayments of previously made customer loans 23
Asset sales 10
Money market borrowings 15
Total Source of Liquidity

Demands on the Mountain Top Savings for Liquidity

Expected quality loan demand 32
Necessary repayments of previous borrowings 15
Other operating expenses 15
Stockholder dividend payments 10
Total Uses of Liquidity Excluding Deposit Withdrawals

Net liquidity deficit = Liquidity supplies − Liquidity demands − Deposit withdrawals

−$10 million = $92 million − $72 million − Deposit withdrawals
Deposit withdrawals = $30

Therefore, expected deposit withdrawals must equal $30 million for the next week.

11-3. First National Bank of Belle Mead has forecast its checkable deposits, time and savings
deposits, and commercial and household loans over the next eight months. The resulting
estimates (in millions) are shown below. Use the sources and uses of funds approach to indicate
which months are likely to result in liquidity deficits and which in liquidity surpluses if these
forecasts turn out to be true. Explain carefully what you would do to deal with each month’s
projected liquidity position.

Checkable Time and Commercial

Month Deposits Savings Deposits Loans Consumer Loans

January $120 $550 $650 $160

February 115 500 650 230
March 100 500 700 210
April 90 485 700 175
May 105 465 710 160
June 80 490 700 200
July 90 525 700 175
August 100 515 675 150

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Estimated
Change from Change from Liquidity -
Total Previous Previous Deficit or
Month Deposits Month Total Loans Month Surplus
January 670 — 810 —
February 615 -55 880 70 -125
March 600 -15 910 30 -45
April 575 -25 875 -35 10
May 570 -5 870 -5 0
June 570 0 900 30 -30
July 615 45 875 -25 70
August 615 0 825 -50 50

January-February, February-March, and May-June will all have liquidity deficits as a result of
decreasing deposits, increasing assets, or both. March-April, June-July, and July-August will all
have liquidity surpluses as a result of increasing deposits, decreasing loans, or both.

First National has several options available:

January-February, February-March, and May-June the bank faces deficits ranging from $30 to
$125 million. These deficits can be met by:
1. aggressive advertising to attract NOW deposits,
2. issuing negotiable CDs in the money market,
3. if they have a holding company, the holding company could sell commercial paper and pass
the proceeds through to the bank subsidiary,
4. borrowing Federal funds,
5. borrowing from the Federal Reserve district bank (although this is not a likely alternative for
most banks),
6. selling securities under agreements to repurchase,
7. selling some of their loans,
8. selling some of their securities, or
9. a combination of a number of these alternatives.

March-April, June-July, and July-August the bank faces anticipated surpluses ranging from $25
to $45 million. These surpluses afford the bank the opportunity to:
1. aggressively pursue new loans,
2. invest in various money market instruments, such as Treasury securities, or,
3. a combination of these alternatives.

Since both periods are relatively short lived, the bank should opt for more temporary measures,
that is, use of the money market. However, if their longer-term forecasts hold promise for
continued growth, they may well want to develop strategies for attracting more deposits and
loans, as well.

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11-4. Queen Savings is attempting to determine its liquidity requirements today (the last day in
August) for the month of September. September is usually a month of heavy loan demand due to
the beginning of the school term and the buildup of business inventories of goods and services
for the fall season and winter. This thrift institution has analyzed its deposit accounts thoroughly
and classified them as explained below.
Management has elected to hold a 85 percent reserve in liquid assets or borrowing capacity for
each dollar of hot money deposits, a 25 percent reserve behind vulnerable deposits, and a 5
percent reserve for its holdings of core funds. Assume time and savings deposits carry a zero
percent reserve requirement and all checkable deposits carry a 3 percent reserve requirement.
Queen currently has total loans outstanding of $2,500 million, which two weeks ago were as
high as $2,550 million. Its loans indicate annual growth rate over the past three years has been
about 6 percent. Carefully prepare low and high estimates for Queen’s total liquidity requirement
for September.

Checkable
Millions of Dollars Deposits Savings Deposits Time Deposits
Hot money funds $10 $ 5 $1,200
Vulnerable funds 65 152 740
Stable (core) funds 85 450 172

Checkable Savings
Time Deposits
Source Deposits Deposits Totals
Hot money funds $10 $ 5 $1200 $1,215
Vulnerable funds 65 152 740 957
Stable (core) funds 85 450 172 707
Totals 160 607 2,112 2,879

Deposit Liquidity Requirement = 0.85 [Net "Hot Money" Funds] + 0.25 [Net Vulnerable Funds]
+ 0.05 [Net "Core" Funds]

a) Net Hot Money Funds = [$10 million − ($10 million × 0.03)] + [$5 million] + [$1,200
million] = $1,214.7 million

b) Net Vulnerable Funds = [$65 million − ($65 million × 0.03)] + [$152 million] + [$740
million] = $955.05million

c) Net Core Funds = [$85 million − ($85 million × 0.03)] + [$450 million] + [$172 million] = $
$704.450 million

Therefore, deposit liquidity requirement = 0.85 × $1,214.7 + 0.25 × $955.05 + 0.05 × $704.450
= $1,032.495 + $238.7625 + $35.2225
= $1,306.48 million

Total liquidity requirement = additional loan demand + deposit liquidity requirement

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Recent experience: Currently, loans total $2,500 million, but recently have been as high as
$2,550 million, or an additional $50 million.

Historically (based on past three years), loan growth has averaged 6 percent annually.

Anticipated additional loan demand (low estimate) = $2,500 × 1.06 = $2,650

Anticipated additional loan demand (high estimate) = $2,550 × 1.06 = $2,703

Therefore, additional loan demand could range from $50 million to as much as $53($2,703 −
$2,650) million.

Total liquidity requirement (low estimate) = $1,306.48 + $50 = $1,356.48 million.

Total liquidity requirement (high estimate) = $1,306.48 + $53 = $1,359.48 million.

11-5 Using the following financial information for Wilson National Bank, calculate as many
of the liquidity indicators discussed in this chapter for Wilson as you can. Do you detect any
significant liquidity trends? Which trends should management investigate?

Most Recent Year Previous Year

Assets:
Cash and due from depository
institutions $ 345,000 $ 358,000
U.S. Treasury securities 176,000 178,000
Other securities 339,000 343,000
Pledged securities 287,000 223,000
Federal funds sold and reverse
repurchase agreements 175,000 131,000
Loans and leases net 2,148,000 1,948,000
Total Assets 3,500,000 3,250,000
Liabilities:
Demand deposits 600,000 556,000
Savings deposits 730,000 721,000
Time deposits 1,100,000 853,000
Total deposits 2,430,000 2,130,000
Core deposits 850,000 644,000
Brokered deposits 58,000 37,000
Federal funds purchased and
repurchase agreements 217,000 237,000
Other money market borrowings 25,000 16,000

Most Recent Year Previous Year

a. Cash Position Indicator: $345,000 ÷ $3,500,000 $358,000 ÷ $3,250,000
Cash and due from banks ÷ Total = 9.86% = 11.02%
assets
b. Liquid securities indicator: $176,000 ÷ $3,500,000 $178,000 ÷ $3,250,000

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

U.S. Govt. sec. ÷ Total assets = 5.03% = 5.48%

c. Net federal funds and repurchase ($175,000 − $217,000) ÷ ($131,000 − $237,000) ÷
agreement position: $3,500,000 $3,250,000
(Fed funds sold − Fed funds = −1.20% = −3.26%
purchased) ÷ Total Assets
d. Capacity ratio: $2,148,000 ÷ $3,500,000 $1,948,000 ÷ $3,250,000
Net loans and leases ÷ Total assets = 61.37% = 59.94%
e. Pledged security ratio: $287,000 ÷ $515,000 $223,000 ÷ $521,000
Pledged securities ÷ Total securities = 55.73% = 42.80%
f. Hot Money Ratio: ($345,000 +$176,000 + ($358,000 + $178,000 +
Money market assets ÷ Volatile $175,000) ÷ ($217,000 + $131,000) ÷ ($237,000 +
liabilities $25,000) $16,000)
= 287.60% = 122.13%
g. Deposit brokerage index: $58,000 ÷ $2,430,000 $37,000 ÷ $2,130,000
Brokered deposits ÷ Total deposits = 2.39% = 1.74%
h. Core deposit ratio: $850,000 ÷ $3,500,000 $644,000 ÷ $3,250,000
Core deposits ÷ Total assets = 24.29% = 19.82%
i. Deposit Composition Ratio: $600,000 ÷ $1,100,000 $556,000 ÷ $853,000
Demand deposits ÷ Time deposits = 54.55% = 65.18%

Wilson Bank appears to have mixed liquidity trends, though most indicators reflect declining
liquidity. Cash assets are falling relative to total assets. Holdings of U.S. Government securities
are also declining relative to total assets. Although, the liquidity has risen due to an increase in
higher sales of net federal funds than purchases, net loans are rising, squeezing out some liquid
assets from total assets and more of the government securities the bank holds are now pledged to
back government deposits. Therefore, are not available for liquidity needs. A positive point is
that the bank has roughly balanced the volatile liabilities it has issued with the money market
assets it holds as the hot money ratio increases. An area of concern that needs management's
attention is the increasing proportion of deposits coming from security brokers. A comforting
offsetting trend, however, is the decline in volatile demand deposits relative to more stable time
deposits.

11-6. The Bank of Your Dreams has a simple balance sheet. The figures are in millions of dollars
as follows:

Assets Liabilities and Equity

Cash $ 100 Deposits $4,000
Securities 1,000 Other liabilities 500
Loans 4,000 Equity 600
Total assets 5,100 Total liabilities and equity 5,100

Although the balance sheet is simple, the bank’s manager encounters a liquidity challenge when
depositors withdraw $500 million.

a. If the asset conversion method is used and securities are sold to cover the deposit drain,
what happens to the size of Bank of Your Dreams?

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

b. If liability management is used to cover the deposit drain, what happens to the size of
Bank of Your Dreams?

a. In this case, the bank would shrink by the amount of deposit withdrawals. Thus, total
assets would decrease to $5,100 – 500 = $4,600.

b. If liability management is used to cover the deposit drain, then the bank would borrow
immediately spendable funds to cover its $500 million dollar withdrawals. Hence, there
would be no change in the size of the bank.

11-7. The liquidity manager for the Bank of Your Dreams needs cash to meet some
unanticipated loan demand. The loan officer has $600 million in loans that he wants to make.
Use the simplified balance sheet provided in the previous problem to answer the following
questions:

a. If asset conversion is used and securities are sold to provide money for the loans, what
happens to the size of Bank of Your Dreams?

b. If liability management is used to provide funds for the loans, what happens to the size
of Bank of Your Dreams?

a. Since securities are simply replaced by loans there will be no change in size.

b. In this case, the size of the bank would increase by the amount of total new loans.
Thus, total assets would increase to $5,100 + 600 = $5,700

11-8. Suppose Abigail Savings Bank's liquidity manager estimates that the bank will
experience a $375 million liquidity deficit next month with a probability of 15 percent, a $200
million liquidity deficit with a probability of 35 percent, a $100 million liquidity surplus with a
probability of 35 percent, and a $250 million liquidity surplus bearing a probability of 15
percent. What is this savings bank’s expected liquidity requirement? What should management
do?

Liquidity Deficits or Associated

Surpluses Probabilities
-$375 million 15 percent
-$200 million 35 percent
+$100 million 35 percent
+$250 million 15 percent
100 percent

The bank's expected liquidity requirement is:

Expected Liquidity Requirement = 0.15 × (-$375 million) + 0.35 × (-$200 million) +
0.35× (+$100 million) + 0.15 × (+$250 million)
= -$56.25 million - $70 million + $35 million + $37.5 million
= -$53.75 million

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

Faced with an expected liquidity deficit the bank's liquidity manager must still begin preparing
for meeting the institution's cash needs through arranging for credit lines or deposits from other
banks and actual or potential deposit customers and strengthening the bank's liquid asset
position.

11-9. First Savings of Rainbow, Iowa, reported transaction deposits of $75 million (the daily
average for the latest two-week reserve computation period). Its nonpersonal time deposits over
the most recent reserve computation period averaged $37 million daily, while vault cash
averaged $5 million. Assuming that reserve requirements on transaction deposits are 3 percent
for deposits over $10.7 million and up to $58.8 million and 10 percent for all transaction deposits
over $58.8 million while time deposits carry a 3 percent required reserve, calculate this savings
institution’s required daily average reserve balance.

Daily required reserves at Fed

= [($58.8 − 10.7) × 0.03] + [($75 – $58.8) × 0.10] + [$37 × 0.03] − $5
= $1.443 + $1.62 + $1.11 − $5= $4.173 − $5.= − $0.827 million

11-10. Elton Harbor Bank has a cumulative legal reserve deficit of $44 million as of the close of
business this Tuesday. The bank must cover this deficit by the close of business tomorrow
(Wednesday).
Charles Tilby, the bank's money desk supervisor, examines the current distribution of money
market and long-term interest rates and discovers the following:

Money Market Instrument Current Market Yield

Federal funds 1.98%

Borrowing from the central bank’s discount 2.25
window
Commercial paper (one-month maturity) 2.33
Bankers' acceptances (three-month maturity) 2.30
Certificates of deposit (one-month maturity) 2.52
Eurodollar deposits (three-month maturity) 3.00
U.S. Treasury bills (three-month maturity) 1.85
U.S. Treasury notes and bonds (1-year maturity) 2.57
U.S. Treasury notes and bonds (5-year maturity) 3.65
U.S. Treasury notes and bonds (10-year maturity) 4.19

One week ago, the bank borrowed $20 million from the Federal Reserve’s discount window,
which it paid back yesterday. The bank had a $5 million reserve deficit during the previous
reserve maintenance period. From the bank’s standpoint, which sources of reserves appear to be
the most promising? Which source would you recommend to cover the bank’s reserve deficit?
Why?

The array of interest rates given in this problem suggests a number of ways Elton Harbor Bank
could meet its reserve requirements. Federal funds borrowing currently is relatively cheaper than

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

most other short-term sources of funds at an annual rate of 1.98 percent. The bank only has to
borrow for 24 hours and can return the borrowed funds on Thursday, thus incurring only one
day's interest cost. Elton may also be able to borrow at the Federal Reserve's discount window at
the relatively cheap interest cost compared to other sources at 2.25 percent, except that it has just
repaid a Fed loan and may have borrowed recently. It would also be good if a CD customer or a
Treasury bills (three-month maturity) could be found to supply a total of $40+ million to cover
the deficit of $5 million reserve deficit. The Federal funds market appears to be the best near
term source of reserves in case no CD customer or Treasury bills holder found.

11-11. Gwynn’s Island Building and Loan Association estimates the following information
regarding this institution’s reserve position at the Federal Reserve for the reserve maintenance
period that begins today (Thursday):

Calculated required daily average legal reserve balance = $760 million

A loan received by the Fed's discount window a week = $70 million
ago that comes due on Friday (day 9)
Planned purchases of U.S. Treasury securities on behalf
of the association and its customers:
Tomorrow (Friday) = $80 million
Next Wednesday (day 7) = $35 million
Next Friday (day 9) = $18 million

Gwynn’s Island also had a closing reserve deficit in the preceding reserve maintenance period of
$5 million. What problems are likely to emerge as this savings association tries to manage its
reserve position over the next two weeks? Relying on the Federal funds market and loans from
the Federal Reserve’s discount window as tools to manage its reserve position, carefully
construct a pro forma daily worksheet for this association’s money position over the next two
weeks. Insert your planned adjustments in discount window borrowing and Federal funds
purchases and sales over the period to show how you plan to manage Gwynn’s Island’s reserve
position and hit your desired reserve target.

Check-clearing estimates over the next 14 days are as follows:

Credit Balance Debit Balance

Day in Millions (+) in Millions (−)
1 +10
2 −60
3 Closed
4 Closed
5 −40
6 −25
7 +30
8 −45
9 −5
10 Closed
11 Closed

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

12 +20
13 −70
14 +10

Estima Check Federal Federal Treas. Clos- Excess Cum. Cum.

ted − Funds Discount Sec. ing or Exc. Closing
Daily Cleari Transactio Window Red. (+) Daily Deficit or Res.
Day Avera ngs ns Borrow Purch Avg. in Def. Bal.
ge Purchases (+) (−) Bal. Legal at Fed.
Reserv (+) Repay(− Res.
e Sales (−) )
Balanc
e
Requir
ed
Deficit from Previous Period - $5 million

1 (Thurs) $760 +10 $765 +5 +5 765

2 (Fri) $760 −60 +205 −80 830 +70 +75 1,595
3 (Sat) $760 830 +70 +145 2,425
4 (Sun) $760 830 +70 +215 3,255
5 (Mon) $760 −40 −205 585 −175 +40 3,840
6 (Tues) $760 −25 560 −200 −160 4,400
7 (Weds) $760 +30 −35 555 −205 −365 4,955
8 (Thurs) $760 −45 510 −250 −615 5,465
9 (Fri) $760 −5 +300 +230 −18 1,017 +257 −358 6,482
10 (Sat) $760 1,017 +257 −101 7,499
11 (Sun) $760 1,017 +257 +156 8,516
12 (Mon) $760 +20 −300 737 −23 +133 9,253
13 (Tues) $760 −70 667 −93 +40 9,920
14 (Wed) $760 +10 +43 720 −40 0 10,640

In this case the bank's money desk manager tried to avoid deepening deficits by periodically -
particularly on Fridays - borrowing heavily in the Federal funds market and at the Federal
Reserve bank. And fortunately, however, by the beginning of the last day (Wednesday) of the
reserve settlement period the bank has a cumulative deficit of $0 million. The planned borrowing
in Federal funds will be enough to prevent any deficit position. It will have a cumulative reserve
balance of $10,640 million as of the final Wednesday in the settlement period and under the law
must have a cumulative reserve balance slightly in excess of $760 million × 14 or $10,640
million. Clearly, this institution has managed its reserve position well.

11-12. Parvis Bank and Trust Co. has calculated its daily average deposits and vault cash
holdings for the most recent two-week computation period as follows:

Net transaction deposits = $ 90,000,000

Nonpersonal time deposits under

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

18 months to maturity = $169,000,000

Eurocurrency liabilities = $ 7,000,000
Daily average balance in vault cash = $ 2,000,000.

Suppose the reserve requirements posted by the Board of Governors of the Federal Reserve
System are as follows:

Net transaction accounts:

$10.7 to $58.8 million 3%
More than $58.8 million 10%
Nonpersonal time deposits:
Less than 18 months 3%
18 months or more 0%
Eurocurrency liabilities—all types 3%

What is this bank's daily average required level of legal reserves? How much must the bank hold
on a daily average basis with the Federal Reserve bank in its district?

Solution:
[($58.8 million − 10.7 million) × 0.03] + [($90 million − $58.8 million) × 0.10] + [($169 million
+ $7 million) × 0.03]
= $1.443 million + $3.12 million + $5.28 million = $9.843 million

Daily average reserve holdings: $9.843 million − $2 million = $7.843 million

11-13. Frost Street National Bank currently holds $750 million in transaction deposits subject to
reserve requirements but has managed to enter into sweep account arrangements with its
transaction deposit customers affecting $150 million of their deposits. Given the current legal
reserve requirements applying to transaction deposits (as mentioned in this chapter), by how
much would Frost Street’s total legal reserves decrease as a result of these new sweep account
arrangements, which stipulate that transaction deposit balances covered by the sweep agreements
will be moved overnight into savings deposits?

Legal reserve would decrease by = 0.03 × ($58.8 − $10.7) + 0.10 × ($150 – $58.8)
= $1.443 + $9.12
= $10.563 million

11-14 Bridgewater Savings Association maintains a clearing account at the Federal Reserve
Bank and agrees to keep a minimum balance of $30 million in its clearing account. Over the two -
week reserve maintenance period ending today Sweetbriar managed to keep an average clearing
account balance of $33 million. If the Federal funds interest rate has averaged 1.75 percent over
this particular maintenance period, what maximum amount would Bridgewater have available in
the form of Federal Reserve credit to help offset any fees the Federal Reserve bank might charge
this association for using Federal Reserve services?

Reserve Credit = Avg. Clearing Balance × Annualized Fed Funds Rate × 14 days/360 days

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Chapter 11 - Liquidity and Reserves Management: Strategies and Policies

= $33,000,000 × 0.0175 × 14 days/360 days

= $22,458.33

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