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

CHAPTER 11 LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIESGoal of This Chapter: The purpose of this chapter is to explore the reasons why financial institutions often face hea

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

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

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

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 PenaltiesVII 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

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, demandsfor 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)

Customer Loan Repayments $108 Deposit Withdrawals $33Sales of Bank Assets 18 Operating Expenses 51

Money-Market Borrowings 43 Repayment of Previous Borrowings 23Nondeposit Service Fees 27 Dividend to Stockholders 140Total Cash Inflows $866 Total Cash Outflows $541

Net LiquidityPosition Total Cash Total CashProjected for = Inflows − Outflowsthe Coming

Week

= $866 million − $541 million

= +$325 million11-4 When is a financial institution adequately liquid?

A financial institution is adequately liquid if it has adequate cash available precisely when cash isneeded, 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 interestrates 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,

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 withinthe 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 andliquidity 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 tomake 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 ofthe 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

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 Total LoansEstimated Change inDeposit Change inLoans

EstimatedLiquidity Deficit

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 arethose 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

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 million11-12 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 depositratio, 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 percentTotal assets $4,446

Net Federal Funds Position:

($48 - $62)Federal funds sold - Federal funds purchased

= = -0.31 percentTotal assets $4,446

Credit Capacity Ratio:

Net loans and leases $3,502

= = 78.77 percentTotal assets $4,446

Deposit Composition Ratio:

Demand deposits $988

= = 36.61 percent Time deposits $2,627

Liquid Securities Indicator:

U.S government securities $185

= = 4.16 percentTotal 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 thatrequires 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:

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 periodCurrently 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

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 millionThe 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

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 atthe 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 chargesfor 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?

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 thelong-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.

Revenues from sale of nondeposit

Acceptable loan requests 60 Repayments of bank borrowings 60Borrowings from the money

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 −

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

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,