Solution manual bank management and financial services 9th edition by rose, peter chap011

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 Liquidity Surplus Liquidity Deficit D Liquidity Time Dimension Immediate Liquidity Longer-term Liquidity E Liquidity Management Problems Rarely are Demands for Liquidity Equal to the Supply of Liquidity There is a Trade-off Between Liquidity and Profitability F Risks Involved I n Management of Liquidity Interest Rate Risk 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 11-1 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies A The Sources and Uses of Funds Approach Trend Component Seasonal Component Cyclical Component B The Structure of Funds Approach C Liquidity Indicator Approach (Ratios) 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 10 Loan Commitments Ratio D The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace 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 VI Legal Reserves and Money Position Management A The Money Position Manager B Legal Reserves C Regulations on Calculating Legal Reserve Requirements Reserve Computation Reserve Maintenance Reserve Requirements Calculating Required Reserves Clearing Balances D Factors Influencing the Money Position Controllable Factors Noncontrollable Factors An Example Use of the Federal Funds Market Other Options besides Fed Funds Bank Size and Borrowing and Lending Reserves for the Money Position 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 11-2 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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: Cash Inflows Customer Loan Repayments Sales of Bank Assets New Deposits Money-Market Borrowings Nondeposit Service Fees $108 18 670 43 27 (In millions of dollars) Cash Outflows Deposit Withdrawals $33 Operating Expenses 51 New Loan Requests 294 Repayment of Previous Borrowings 23 Dividend to Stockholders 140 Total Cash Inflows $866 Total Cash Outflows 11-3 $541 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies Net Liquidity Position Projected for the Coming Week Total Cash = Inflows Total Cash − Outflows = $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 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, 11-4 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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, lastminute borrowings if he or she knows what the bank's principal depositors and creditors will 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 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 11-5 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 Total Deposits $112 132 121 147 151 139 Estimated Total Loans $87 95 102 113 101 124 Change in Deposit $— +20 −11 +26 +4 −12 Change in Loans $— +8 +7 +11 −12 +23 Estimated Liquidity Deficit or Surplus $— +12 −18 +15 +16 −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 percent liquidity reserve The 11-6 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies thrift expects its loans to grow percent annually; its loans currently total $117 million but have recently reached $132 million If reserve requirements on liabilities currently stand at 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: Cash and deposits due from other banks $633 = = 14.24 percent Total assets $4,446 Net Federal Funds Position: ( $48 - $62 ) Federal funds sold - Federal funds purchased = = -0.31 percent Total assets $4,446 Credit Capacity Ratio: Net loans and leases $3,502 = = 78.77 percent Total assets $4,446 Deposit Composition Ratio: 11-7 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies Demand deposits $988 = = 36.61 percent  Time deposits $2,627 Liquid Securities Indicator: U.S government securities $185 = = 4.16 percent Total assets $4,446 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: 11-8 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 Reserves = 0.03 × [First $58.8 − $910.7 million] + 0.10 × [Amount in 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 11-9 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 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 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? 11-10 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 Deposit inflows Scheduled loan repayments Acceptable loan requests Borrowings from the money market $100 Sales of bank assets 95 Stockholder dividend payments Revenues from sale of nondeposit 90 services 60 Repayments of bank borrowings $ 40 150 80 Operating expenses 95 60 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 Deposit inflows Scheduled loan repayments Acceptable loan requests Borrowings from the money market Sales of bank assets Stockholder dividend payments Revenues from sale of nondeposit services Repayment of bank borrowings Operating expenses $100 $95 $90 $60 $80 $40 $150 − + + − + + − $95 $60 $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 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, 11-11 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 Revenues from nondeposit service sales Scheduled repayments of previously made customer loans Asset sales Money market borrowings Total Source of Liquidity Demands on the Mountain Top Savings for Liquidity Expected quality loan demand Necessary repayments of previous borrowings Other operating expenses Stockholder dividend payments Total Uses of Liquidity Excluding Deposit Withdrawals $26 18 23 10 15 32 15 15 10 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 to deal with each month’s projected liquidity position Month January February March April May June July August Checkable Deposits Time and Savings Deposits Commercial Loans Consumer Loans $120 115 100 90 105 80 90 100 $550 500 500 485 465 490 525 515 $650 650 700 700 710 700 700 675 $160 230 210 175 160 200 175 150 11-12 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies Month January February March April May June July August Total Deposits 670 615 600 575 570 570 615 615 Change from Previous Month — -55 -15 -25 -5 45 Total Loans 810 880 910 875 870 900 875 825 Change from Previous Month — 70 30 -35 -5 30 -25 -50 Estimated Liquidity Deficit or Surplus -125 -45 10 -30 70 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: aggressive advertising to attract NOW deposits, issuing negotiable CDs in the money market, if they have a holding company, the holding company could sell commercial paper and pass the proceeds through to the bank subsidiary, borrowing Federal funds, borrowing from the Federal Reserve district bank (although this is not a likely alternative for most banks), selling securities under agreements to repurchase, selling some of their loans, selling some of their securities, or 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: aggressively pursue new loans, invest in various money market instruments, such as Treasury securities, or, 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 11-13 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 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 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 percent Carefully prepare low and high estimates for Queen’s total liquidity requirement for September Millions of Dollars Hot money funds Vulnerable funds Stable (core) funds Checkable Deposits $10 65 85 Savings Deposits $ 152 450 Source Hot money funds Vulnerable funds Stable (core) funds Totals Checkable Deposits $10 65 85 160 Savings Deposits $ 152 450 607 Time Deposits $1,200 740 172 Time Deposits $1200 740 172 2,112 Totals $1,215 957 707 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 11-14 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 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 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 Assets: Cash and due from depository institutions U.S Treasury securities Other securities Pledged securities Federal funds sold and reverse repurchase agreements Loans and leases net Total Assets Liabilities: Demand deposits Savings deposits Time deposits Total deposits Core deposits Brokered deposits Federal funds purchased and repurchase agreements Other money market borrowings a Cash Position Indicator: Cash and due from banks ÷ Total assets b Liquid securities indicator: Previous Year $ 345,000 176,000 339,000 287,000 $ 358,000 178,000 343,000 223,000 175,000 2,148,000 3,500,000 131,000 1,948,000 3,250,000 600,000 730,000 1,100,000 2,430,000 850,000 58,000 556,000 721,000 853,000 2,130,000 644,000 37,000 217,000 25,000 237,000 16,000 Most Recent Year $345,000 ÷ $3,500,000 = 9.86% Previous Year $358,000 ÷ $3,250,000 = 11.02% $176,000 ÷ $3,500,000 $178,000 ÷ $3,250,000 11-15 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies U.S Govt sec ÷ Total assets c Net federal funds and repurchase agreement position: (Fed funds sold − Fed funds purchased) ÷ Total Assets d Capacity ratio: Net loans and leases ÷ Total assets e Pledged security ratio: Pledged securities ÷ Total securities f Hot Money Ratio: Money market assets ÷ Volatile liabilities g Deposit brokerage index: Brokered deposits ÷ Total deposits h Core deposit ratio: Core deposits ÷ Total assets i Deposit Composition Ratio: Demand deposits ÷ Time deposits = 5.03% ($175,000 − $217,000) ÷ $3,500,000 = −1.20% = 5.48% ($131,000 − $237,000) ÷ $3,250,000 = −3.26% $2,148,000 ÷ $3,500,000 = 61.37% $287,000 ÷ $515,000 = 55.73% ($345,000 +$176,000 + $175,000) ÷ ($217,000 + $25,000) = 287.60% $58,000 ÷ $2,430,000 = 2.39% $850,000 ÷ $3,500,000 = 24.29% $600,000 ÷ $1,100,000 = 54.55% $1,948,000 ÷ $3,250,000 = 59.94% $223,000 ÷ $521,000 = 42.80% ($358,000 + $178,000 + $131,000) ÷ ($237,000 + $16,000) = 122.13% $37,000 ÷ $2,130,000 = 1.74% $644,000 ÷ $3,250,000 = 19.82% $556,000 ÷ $853,000 = 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 Cash Securities Loans Total assets $ 100 1,000 4,000 5,100 Liabilities and Equity Deposits $4,000 Other liabilities 500 Equity 600 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? 11-16 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 Surpluses -$375 million -$200 million +$100 million +$250 million Associated Probabilities 15 percent 35 percent 35 percent 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 11-17 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 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 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 Borrowing from the central bank’s discount window Commercial paper (one-month maturity) Bankers' acceptances (three-month maturity) Certificates of deposit (one-month maturity) Eurodollar deposits (three-month maturity) U.S Treasury bills (three-month maturity) U.S Treasury notes and bonds (1-year maturity) U.S Treasury notes and bonds (5-year maturity) U.S Treasury notes and bonds (10-year maturity) 1.98% 2.25 2.33 2.30 2.52 3.00 1.85 2.57 3.65 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 11-18 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 A loan received by the Fed's discount window a week 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) Next Wednesday (day 7) Next Friday (day 9) = $760 million = $70 million = $80 million = $35 million = $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: Day 10 11 Credit Balance in Millions (+) +10 Debit Balance in Millions (−) −60 Closed Closed −40 −25 +30 −45 −5 Closed Closed 11-19 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies 12 13 14 +20 −70 +10 Estima Check ted − Daily Cleari Averag e Reserv e Balanc e Requir Day Federal Funds Transactio ns Purchases (+) Sales (−) Federal Discount Window Borrow (+) Repay(− ) Treas Sec Red (+) Purch (−) Closing Daily Avg Bal Excess or Deficit in Legal Res Cum Exc or Def Cum Closing Res Bal at Fed $765 830 830 830 585 560 555 510 1,017 1,017 1,017 737 667 720 +5 +70 +70 +70 −175 −200 −205 −250 +257 +257 +257 −23 −93 −40 +5 +75 +145 +215 +40 −160 −365 −615 −358 −101 +156 +133 +40 765 1,595 2,425 3,255 3,840 4,400 4,955 5,465 6,482 7,499 8,516 9,253 9,920 10,640 Deficit from Previous Period - $5 million (Thurs) (Fri) (Sat) (Sun) (Mon) (Tues) (Weds) (Thurs) (Fri) 10 (Sat) 11 (Sun) 12 (Mon) 13 (Tues) 14 (Wed) $760 $760 $760 $760 $760 $760 $760 $760 $760 $760 $760 $760 $760 $760 +10 −60 +205 −40 −25 +30 −45 −5 −205 +20 −70 +10 −300 −80 −35 +300 +230 +43 −18 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 Nonpersonal time deposits under = $ 90,000,000 11-20 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 More than $58.8 million Nonpersonal time deposits: Less than 18 months 18 months or more Eurocurrency liabilities—all types 3% 10% 3% 0% 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 twoweek 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 11-21 Chapter 11 - Liquidity and Reserves Management: Strategies and Policies = $33,000,000 × 0.0175 × 14 days/360 days = $22,458.33 11-22 ... 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. .. 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... 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;