Chapter Eleven

Liquidity and Reserves Management:

Strategies and Policies
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11-2

Key Topics
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

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Introduction
One of the most important tasks the management of any
financial institution faces is ensuring adequate liquidity at all
times
A financial firm is considered to be liquid if it has ready
access to immediately spendable funds at reasonable cost at
precisely the time those funds are needed
This suggests that a liquid financial firm either has
The right amount of immediately spendable funds on hand when they
are required
They can raise liquid funds in timely fashion by borrowing or selling
assets

Lack of adequate liquidity can be one of the first signs that a

financial institution is in trouble
A financial firm can be closed if it cannot raise sufficient
liquidity even though, technically, it may still be solvent

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The Demand for and Supply of Liquidity

Demands for Liquidity
Customer deposit withdrawals
Credit requests from quality loan customers
Repayment of nondeposit borrowings
Operating expenses and taxes
Payment of stockholder dividends
Supplies of Liquid Funds
Incoming customer deposits
Revenues from the sale of nondeposit services
Customer loan repayments
Sales of bank assets
Borrowings from the money market
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The Demand for and Supply of Liquidity

(continued)
These various sources of liquidity demand and supply come
together to determine each financial firms net liquidity position
at any moment in time
That net liquidity position (L) at time t is

Liquidity Deficit is Lt < 0 and Liquidity Surplus is Lt > 0

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The Demand for and Supply of Liquidity

(continued)
The essence of liquidity management problems for
financial institutions
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
The more resources are tied up in readiness to meet
demands for liquidity, the lower is that financial firms
expected profitability (other factors held constant)

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Why Financial Firms Often Face Significant

Liquidity Problems
Imbalances between maturity dates of their assets and
liabilities
High proportion of liabilities (especially demand deposits
and money market borrowings) are subject to immediate
repayment
Sensitivity to changes in interest rates
May affect customer demand for deposits
May affect customer demand for loans

Central role in the payment process, reputation and public

confidence in the system

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11-8

Strategies for Liquidity Managers

Think about what is a liquid asset?
Liquid assets have a ready market, stable price and are
reversible

Identify strategies for liquidity management

Asset Liquidity Management or Asset Conversion Strategy
This strategy calls for storing liquidity in the form of liquid assets (Tbills, fed funds loans, CDs, etc.) and selling them when liquidity is
needed

Borrowed Liquidity or Liability Management Strategy

This strategy calls for the bank to purchase or borrow from the
money market to cover all of its liquidity needs

Balanced Liquidity Strategy

The combined use of liquid asset holdings (Asset Management) and
borrowed liquidity (Liability Management) to meet liquidity needs

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Strategies for Liquidity Managers (continued)

Guidelines for Liquidity Managers
Keep track of all fund-using and fund-raising departments
Know in advance withdrawals by the biggest credit or
deposit customers
Priorities and objectives for liquidity management should
be clear
Liquidity needs must be evaluated on a continuing basis

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Estimating Liquidity Needs

Sources and Uses of Funds Approach

Structure of Funds Approach
Liquidity Indicator Approach
The Ultimate Standard for Assessing Liquidity
Needs: Signals from the Marketplace

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11-11

Estimating Liquidity Needs (continued)

Sources and Uses of Funds Approach
Loans and deposits must be forecast for a given liquidity
planning period
The estimated change in loans and deposits must be calculated
for the same planning period
The liquidity manager must estimate the banks net liquid funds
by comparing the estimated change in loans to the estimated
change in deposits

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Estimating Liquidity Needs (continued)

Sources and Uses of Funds Approach

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Estimating Liquidity Needs (continued)

Sources and Uses of Funds Approach

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Estimating Liquidity Needs (continued)

Sources and Uses of Funds Approach

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Estimating Liquidity Needs (continued)

Structure of Funds Approach
A Banks Deposits and Other Sources of Funds Divided Into
Categories. For Example:
Hot Money Liabilities (volatile liabilities)
Vulnerable Funds
Stable Funds (core deposits or core liabilities)
Liquidity Manager Set Aside Liquid Funds According to Some
Operating Rule

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Estimating Liquidity Needs (continued)

Structure of Funds Approach
For example, the manager may decide to set up
A 95 percent liquid reserve behind all hot money funds (less any
required legal reserves held behind hot money deposits)
30 percent in liquid reserves for vulnerable deposit and nondeposit
liabilities
15 percent or less in liquid reserves for stable (core) funds sources

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Estimating Liquidity Needs (continued)

Structure of Funds Approach
Combining both loan and deposit liquidity requirements, this
institutions total liquidity requirement would be

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Estimating Liquidity Needs (continued)

Structure of Funds Approach
Many financial firms like to calculate their expected liquidity
requirement, based on the probabilities they assign to different
possible outcomes

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11-19

Estimating Liquidity Needs (continued)

Liquidity Indicator Approach
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Cash position indicator

Liquid securities indicator
Net federal funds and repurchase agreements position
Capacity ratio
Pledged securities ratio
Hot money ratio
Deposit brokerage index
Core deposit ratio
Deposit composition ratio
Loan commitments ratio

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11-20

Estimating Liquidity Needs (continued)

The Ultimate Standard for Assessing Liquidity Needs:
Signals from the Marketplace
Liquidity managers should closely monitor the following market
signals:
1.
2.
3.
4.
5.
6.

Public confidence
Stock price behavior
Risk premiums on CDs and other borrowings
Loss sales of assets
Meeting commitments to credit customers
Borrowings from the central bank

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Legal Reserves and Money Position

Management
Legal Reserves
Those assets that law and central bank regulation say must be
held during a particular time period

The current system of accounting for legal reserves is called

lagged reserve accounting (LRA)
The daily average amount of deposits and other reservable
liabilities are computed using information gathered over a twoweek period stretching from a Tuesday through a Monday two
weeks later
This interval of time is known as the reserve computation period
The daily average amount of vault cash each depository
institution holds is also figured over the same two-week
computation period
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EXHIBIT 111 Federal Reserve Rules for Calculating a Weekly

Reporting Depository Institutions Required Legal Reserves

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Legal Reserves and Money Position

Management (continued)
Legal Reserves
Only two kinds of assets can be used for this purpose
1.
2.

Cash in the vault

Deposits held in a reserve account with the regional Fed

The reserve requirement in 2010 was 3 percent of the end-of-the-day

daily average amount held over a two-week period, from $10.7 million
up to $58.8 million
The first $10.7 million have zero legal reserves
The $58.8 million figure is known as the reserve tranche and changes
every year based on deposit growth
Transaction deposits over $58.8 million held by the same depository
institution carried a 10 percent legal reserve requirement
This annual legal reserve adjustment is designed to offset inflation
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Legal Reserves and Money Position

Management (continued)
Calculating Required Reserves
The largest depository institutions must hold the largest
percentage of legal reserves
Each reservable liability item is multiplied by the stipulated
reserve requirement percentage to derive each depositorys total
legal reserve requirement

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Legal Reserves and Money Position

Management (continued)
Calculating Required Reserves
The largest depository institutions must hold the largest
percentage of legal reserves
Each reservable liability item is multiplied by the stipulated
reserve requirement percentage to derive each depositorys total
legal reserve requirement

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Legal Reserves and Money Position

Management (continued)
Clearing Balances
In addition to holding a legal reserve account at the central bank, many
depository institutions also hold a clearing balance with the Fed to
cover any checks or other debit items drawn against them
For example, suppose a bank had a clearing balance averaging $1
million during a particular two-week maintenance period and the
Federal funds interest rate over this same period averaged 5.50 percent
Then it would earn a Federal Reserve credit of

Assuming a 360-day year for ease of computation, this bank could

apply up to $2,138.89 to offset any fees charged to the bank for its use
of Federal Reserve services
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Legal Reserves and Money Position

Management (continued)
Factors Influencing the Money Position

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Legal Reserves and Money Position

Management (continued)
Sweep Accounts
Volume of legal reserves held at the Fed has declined in recent years
largely due to sweep accounts
A contractual account between a bank and a customer that permits
the bank to move funds out of a customers checking account
overnight in order to generate higher returns for the customer and
lower reserve requirements for the bank
Retail Sweep
Business Sweep

The sweeps market is likely to change in form and importance due

to the recent passage of the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2009

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Legal Reserves and Money Position

Management (continued)
Other Factors to Influence Legal Reserves
Use of Fed Funds Market
The cheapest source
But very volatile
Managers rely on the Fed funds target rate (the most volatile on the
settlement date)

Other Options

Sell liquid securities

Draw upon excess correspondent balances
Enter into repurchase agreements for temporary borrowings
Sell new time deposits
Borrow in the Eurocurrency market

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EXHIBIT 112 Movements in the Effective Federal Funds Rate, Its Target
(the Intended Federal Funds) Rate, and the Discount (Primary Credit) Rate
for Depository Institutions Seeking Credit from the Federal Reserve Banks

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Factors in Choosing among the Different

Sources of Reserves
In choosing which source of reserves to draw upon to cover a
legal reserve deficit, managers must carefully consider several
aspects of their institutions need for liquid funds:
1. Immediacy of need
2. Duration of need
3. Access to the market for liquid funds
4. Relative costs and risks of alternative sources of funds
5. The interest rate outlook
6. Outlook for central bank monetary policy
7. Rules and regulations applicable to a liquidity source

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Central Bank Reserve Requirements around

the Globe
Not all central banks impose legal reserve requirements on the
depository institutions they regulate
For example, the Bank of England has not established official reserve
requirements for its banks
There is a trend among central banks around the globe to eliminate,
suspend, or at least make less use of the reserve requirement tool, in
part because it is so difficult to control
A notable exception is the European Central Bank (ECB)

Even if central banks imposed no reserve requirements,

managers of depository institutions would still have a demand
for cash reserves
All depository institutions at one time or another need immediately
available funds to handle customer withdrawals, meet new loan
demand, and satisfy other emergency cash needs
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Quick Quiz
What are the principal sources of liquidity demand for a financial firm?
What are the principal sources from which the supply of liquidity comes?
Why do financial firms face significant liquidity management problems?
What are the principal differences among asset liquidity management,
liability management, and balanced liquidity management?
How does the sources and uses of funds approach help a manager estimate
a financial institutions need for liquidity?
How can the discipline of the marketplace be used as a guide for making
liquidity management decisions?
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?
What impact has recent financial reform legislation had on raising shortterm cash?
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