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Copyright © 2000 by Harcourt, Inc. All rights reserved.

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Chapter 19Asset Management: Liquidity Reserves and

the Securities Portfolio


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Why is liquidity important?

As part of the intermediation function, depository institutions provide liquidity for customers.

• Depositors are promised immediate or almost immediate repayment on demand.

• Borrowers expect uninterrupted funding from loan agreements.


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Regulators require liquidity.

• Depositories operate under a set of liquidity requirements established at either the state or federal level.


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Liquidity: The Risk/Return Trade-off

The conflict between the risk of illiquidity and a desire to maintain enough liquidity to avoid a crisis is at the heart of liquidity management.• Liquid assets contribute little to NIM.

Liquidity planning requires:• determining funds necessary to meet reserve

requirements; and• estimating the liquidity needs for normal and

unexpected deposit withdrawal and loan demand.


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Historical Rationale for Reserve Requirements

Prior to the 1930’s - the prevention of liquidity crises in individual institutions or geographical regions

By 1931- a tool for controlling the amount of credit extended by banks

By the 1950’s - an important element of monetary policy

By the 1990’s - an unproductive regulatory tax


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Managing Required Reserves

Required reserves must be held as vault cash or as deposits in Federal Reserve District banks.

The size of total deposits determines whether an institution is subjected to weekly or quarterly reporting.

If reserves are 4% below the daily average minimum reserve required, the institution is penalized by the Fed but is allowed to carry the deficit into the next period.


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If reserves are 4% higher than the minimum, the excess may be carried into the next reporting period.

The Fed does not pay interest on reserve deposits.

Quarterly reporting institutions are subject to lagged reserve accounting (LRA).

• The quantity of reserves is determined prior to the date reserves must be held.


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Weekly reporting institutions are subject to contemporaneous reserve accounting (CRA).

• Required reserves are determined by deposit levels in the same period in which they are maintained.


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CRA Rules

LRA applies to reserves held against nontransactions accounts.

• Currently, nonpersonal time deposits and Eurocurrency liabilities have a 0% reserve requirement.

Transactions deposits are subject to CRA. The maintenance period under CRA is the

two week period during which reserve balances must be on deposit.


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The reserve computation period is also two weeks, but begins two days prior to the maintenance period and ends two days earlier.

The average daily level of reserves during the maintenance period must meet the required percentages on the average level of deposits during the computation period.


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MTWTFSS MTWTFSS MTWTFSS MTWTFS MTWTFSS

2-Week Computation Period Nontransactions Deposits

(Days 1 - 14)

2-Week Maintenance Period for Transactions Deposits

(Days 15 - 28)

2-Week Reserve Maintenance Period

Days (17 - 30)

RESERVE REQUIREMENT COMPUTATION: CONTEMPORANEOUS RESERVE ACCOUNTING

Under CRA, the reserve computation period for transactions accounts and the reserve maintenance period overlap substantially, increasing the difficulty of managing reserves.


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Contemporaneous Computation Period

Day # Day

Non-Transactions

Liabilities Day # DayVault Cash

Transactions Deposits Day # Day

Reserve Balances

RESERVE BALANCE COMPUTATIONS (MILLIONS)

Under CRA , management of reserve balances involves complex relationships. The last two days of the maintenance period are particularly important for assuring that average required balances are achieved.Lagged Computation Period Maintenance Period

1 T $4502 W 4853 T 4604 F 4455 S 4456 S 4457 M 4408 T 4259 W 465

10 T 450 11 F 475 12 S 475 13 S 475 14 M 460

Average : $456,786

15 T $9.5 $1,08216 W 9.3 1,09017 T 9.6 1,05518 F 9.8 1,08519 S 9.8 1,10820 S 9.8 1,11521 M 9.1 1,10022 T 9.5 1,11023 W 9.2 1,11224 T 9.8 1,15025 F 9.9 1,15526 S 9.9 1,13827 S 9.9 1,25628 M 10.3 1,338

Average: $9,671 $1,135,286

17 T $9318 F 99 19 S 10420 S 10121 M 9722 T 10323 W 10524 T 9625 F 9826 S 9427 S 10228 M 9929 T30 W

12 day average: $99,250


19-13A 10% requirement applied to all transactions deposits of over $47.8 million

Required average daily reserve balances:

0% on nontransactions liabilities (lagged) $0.000

+ 3% of first $47.6 mil. in transactions deposits (contemporaneous) $1.434

+ 10% of remaining transactions deposits (contemporaneous) $108.749

- Average vault cash ($9,671)

Average daily required $100.512a

Reserve adjustment required:

Cumulative reserves required (daily average × 14) $1407.168

Less accumulated total in first 12 days $1191.000

Total amount required for last two days 216.168

Average balance required last two days 108.084

Maximum negative carryover allowed:

Daily requirement × 0.04 $4.021aDoes not add because of rounding; slight rounding differences may also affect other calculations.


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Estimating Liquidity Needs Above Reserve Requirements

The amount of liquidity needed depends on:• predicted loan demand;• deposit withdrawals adjusted for cyclical and

seasonal factors, and growth;• the cushion desired for unexpected loan demand

and deposit withdrawals; and• risk preferences of stakeholders in the

institution.


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Liquidity management is related to liability management.• Institutions with multiple sources of short-term

borrowing require less liquidity in terms of short-term assets on balance sheets.


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Estimating Liquidity Needs for Operations

Divide asset categories into liquid and illiquid components.

Divide sources of funds into volatile and nonvolatile sources.

Determine additional drains on liquidity.


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I. Original Assumptions Assets

Cash $ 209.7 10% $ 21.0 $ 188.7Investments 1,037.6 59 609.4 428.2Loans 1,214.4 0 0.0 1,214.4Other Assets 171.0 0 15.0 156.0

Total $2,632.7 $645.4 $1,987.3

ESTIMATING LIQUIDITY NEEDS FOR OPERATIONS

Institutions need to forecast potential liquidity positions and plan to avoid deficits. The approach illustrated identifies the volatility of funds sources and estimates whether liquid assets could cover large outflows and meet additional loan demand.

Total Liquid(Millions) % Liquid Illiquid


19-18Total Volatile

(Millions) % Volatile Nonvolatile

Fund SourcesDeposits $1,755.0 7% $130.0 $1,625.0 Other Liabilities 674.0 82 549.7 124.3Equity 203.7 0 0.0 203.7

Total $2,632.7 $679.7 $1,953.0Liquidity deficit (liquid assets -volatile funds):

$645.4 - $679.7 = ($34.3)

Total Liquid(Millions) % Liquid Illiquid

II. Additional Loan Demand Assets

Cash $ 209.7 10% $ 21.0 $ 188.7Investments 1,037.6 59 609.4 428.2Loans 1,214.4 -1 (12.1) 1,226.5Other Assets 171.0 9 15.0 156.0

Total $2,632.7 $633.3 $1,999.4Liquidity deficit (liquid assets - volatile funds):

$633.3 - $679.7 = ($46.4)


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In the “Original assumptions” section, loan demand is assumed to be completely met by maturing loans or stable deposits.

The “Additional loan demand” section builds in coverage for unexpected loan demand by assigning a negative balance equal to 1% of that already forecasted.


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Managing the Liquidity Position

Use of liability management• Borrowing from regulators.

• Borrowing from nondeposit creditors in financial markets.

• Small institutions are limited to Fed funds purchases and borrowing from regulators.

Use of asset management• Liquidating assets from the securities portfolio.

• Relied on by small institutions.


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Factors Influencing Liquidity Management

Size and Financial Stability Industry Membership Risk/Return Preferences of Managers and

Owners


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Borrowing from Regulators

The Discount Window

• Available for all depositories subject to reserve requirements.

• Borrowing is permitted under three conditions:– to meet temporary liquidity needs;– to meet seasonal credit demand; and – for special “extended credit” purposes.

FHLB Advances

• Tends to be longer-term borrowing than the Fed’s discount window loans.


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• Primarily used by S&Ls for the purpose of helping institutions meet unmet mortgage demand.

• The volume of advances is limited to an institution’s net worth.

• An institution’s reinvestment in the community and its willingness to lend to first-time homebuyers is considered in deciding whether to grant the advance.

Source of Borrowing for Credit Unions

• Central Liquidity Facility (CLF), arm of NCUA.

• Fed discount window.

• Corporate Credit Unions (membership required).


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The Securities Portfolio As a Source of Liquidity

Choosing an optimal combination of liquid versus higher-yielding assets is an integral part of liquidity management.

Pyramid of reserves under stored liquidity.• Primary reserves - cash above reserve requirements.• Secondary reserves - short-term marketable

securities not pledged for public deposits.• Tertiary reserves - mortgage securities and other

long-term securities, held for income purposes, that can be sold if necessary.


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Securitization of Loans and Loan Sales as Liquidity Sources

Loans can be sold to long-term investors such as pension funds and insurance companies.

Securitization helps:

• shorten the funding gaps;

• reduce credit risk if loans are sold without recourse; and

• generate a steady source of liquidity and fee income if an institution has processes set in place to regularly engage in loan sales.


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Depository Institutions Investment Portfolio Management Objectives

Providing liquidity, either through maturing securities or as stored liquidity.

Providing income, particularly countercyclical income, to keep funds fully employed.

Satisfying pledging requirements.


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Reducing taxes through tax swaps or holding municipal securities.

Using the portfolio to make adjustments for the bank’s asset and liability position, including the banks overall capital and interest rate risk.


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Portfolio Management: Regulatory Restrictions

Depositories are not allowed to hold equity securities in their investment portfolios.

Investments consist of fixed income securities of various types.

• Securities with ratings below investment grade (i.e., below BBB/Baa) are not allowed.


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Investment Strategies Used to Provide Liquidity and Investment Returns

Matching Cash Flows

• The maturities of securities should closely match the forecasted timing and quantity of cash needs to meet loan demand and deposit withdrawal.

Ladder of Maturities

• Spreads the maturity of securities held for liquidity purposes evenly throughout a given period.

• Funds from maturing securities are reinvested in assets with the longest maturity chosen.


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• The strategy does not attempt to optimize the investment returns for the institution.

• It is a passive approach, not requiring personnel to manage the securities portfolio.

Barbell or Split Maturity• Invest funds in either end of the yield curve but not

in the middle.

• Some very liquid assets are held but (assuming an upward-sloping yield curve) allows a large investment in higher-return, long-term securities.

• Requires interest rate forecasts to determine the proportionate investments at either end of the yield curve.


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Buffer Portfolio Strategy

• Most of the securities are concentrated in the short-term end of the maturity schedule.

• The average maturity under this strategy is considerably lower than under either the ladder-of-maturity or the barbell strategy.


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Real World Considerations in Investment Strategies

Bank investment managers may be pressured to invest in short-term or long-term maturities at undesirable time periods to make up for low profitability.

For community relations reasons, a bank may feel obligated to support its municipalities, limiting opportunities to geographically diversify the portfolio.


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Banks may be hesitant to take a loss and make a tax swap that would improve the bank’s profitability in the future.

Investment accounting rules may reduce a manager’s ability to respond to changing market conditions for securities classified as “held to maturity.”


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Mortgage-Backed Securities (MBS)

Approximately 55% of the securities portfolio of banks and 74% of the portfolio of savings institutions is in the form of MBS.

Agencies active in MBS include:• Government National Mortgage Association

(GNMA = Ginnie Mae);

• Federal National Mortgage Association (FNMA = Fannie Mae); and

• Federal Home Loan Mortgage Corporation (FHLMC = Freddie Mac).


19-35 GNMA does not create MBS but provides guarantees to

investors for the timely pass-through of interest and principal payments for MBS created by banks, thrifts and mortgage companies.• Focus on FHA/VA mortgages.

FNMA purchases mortgages and creates MBS for FHA/VA and conventional mortgages.• FNMA also guarantees the timely payment of interest and principal.

FHLMC purchases and creates MBS from conventional and insured mortgages.


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Different Types of Mortgage-Backed Securities

Mortgage-backed bonds • Bonds are collateralized by mortgages on the

balance sheet, and thus are not securitizations.

Mortgage pass-through securities or certificates of participation • These are securitizations whereby shares in

interest and principal payments on a pool of mortgages are passed on to investors who purchase the securities.


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CMOs

• These are securities created from mortgage pass-throughs.

• Pools of mortgages are converted into different maturities by allowing the first tranche of bonds (A-class bonds) to be repaid their principal payments first when mortgage holders prepay their mortgages in the pool.

• Repayment of principal follows in the order of the tranches or classes created.


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Investors have less prepayment uncertainty than they would with an ordinary pass-through security.

Investors have a better estimate in terms of the likely maturity and yield that should be offered on a particular type of CMO.

Because of their prepayment risk, pass-through MBS often demonstrate negative convexity.

Investors in pass-through securities demand a higher coupon rate for their prepayment risk.

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Economy & Finance

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