CHAPTER 9

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 and Liquidity Surpluses and Deficits

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

B. The Structure of Funds Approach

C. Liquidity Indicator Approach

D. The Ultimate Standard for Assessing Liquidity Needs: Signals from the Marketplace

1. Public confidence

2. Stock price behavior

3. Risk premiums on CDs and other borrowings

4. Loss sales of assets

5. Meeting commitments to credit customers

6. Borrowings from the central bank

VI. Legal Reserves and Money Position Management

A. The Money Position Manager

B. Legal Reserves

C. Regulations on Calculating Legal Reserve Requirements

1. Reserve Computation

2. Reserve Maintenance

3. Reserve Requirements

4. Calculating Required Reserves

5. Penalty for a Reserve Deficit

6. Clearing Balances

D. Factors Influencing the Money Position

1. Controllable Factors

2. Noncontrollable Factors

3. An Example

4. Use of the Federal Funds Market

5. Other Options besides Fed Funds

6. Bank Size and Borrowing and Lending Reserves for the Money Position

7. Overdraft Penalties

VII. Factors in Choosing among the Different Sources of Reserves

A. Immediacy of need

B. Duration of need

C. Access to the market for liquid funds

D. Relative costs and risks of alternative sources of funds

E. The interest rate outlook

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 deposits and from credit requests. However, demands for liquidity can also come from paying off previous borrowings, operating expenses and taxes incurred during operations and from payment of a cash dividend 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 Concept Check 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 banks projected net liquidity position for the coming week? (In millions of dollars)Cash InflowsCash Outflows

Customer Loan Repayments$108Deposit Withdrawals$33

Sales of Bank Assets18Operating Expenses51

New Deposits670New Loan Requests294

Money-Market Borrowings43Repayment of Previous Borrowings23

Nondeposit Service Fees 27Dividend to Stockholders 140

Total Cash Inflows$866Total Cash Outflows$541

Net Liquidity

PositionTotal CashTotal Cash

Projected for= Inflows- Outflows

the Coming Week

= $866 million - $541 million

= + $325 million

11-4. When is a financial institution adequately liquid?

A financial institution is adequately liquid if it has adequate cash available precisely when cash is needed at a reasonable cost. Management can monitor the cash position over time, and also monitor what is happening to its cost of funds. One indicator of the adequacy of the liquidity position is its cost - a rising interest cost 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;(2) The sensitivity of changes to their assets and liabilities values towards market interest-rate movements; and

(3) Their central role in the payments process.

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

Asset management is a strategy for meeting liquidity needs, used mainly by smaller banks, in which 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 demands for liquidity made against a bank. Balanced liquidity management calls for using both asset management and liability management to cover a bank's liquidity needs.

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

It is important for a liquidity manager to: (a) keep track of the activities of other departments within the bank; (b) know in advance the planned activities of the bank's largest credit and deposit customers; (c) set clear priorities and objectives in liquidity management; and (d) react quickly to liquidity deficits and liquidity surpluses.

Liquidity managers must know what other departments within the institution are doing because their activities affect the liquidity position and liquidity management decisions. The liquidity manager can make better decisions to profitably invest surplus liquid funds or avoid costly, last-minute borrowings if he or she knows what the bank's principal depositors and creditors will do in advance. By setting clear priorities and objectives the liquidity manager has a better chance to make sound decisions plus an ability to act quickly to invest surpluses in order to gain maximum income or avoid costly deficits and prolonged borrowings.

11-8. How does the sources and uses of funds approach help a manager estimate a financial institutions need for liquidity?

The sources and uses of funds approach estimates future deposit inflows and estimated outflows of funds associated with expected loan demand and calculates the net difference between these items in each planning period.

When sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the difference between sources and uses of funds. When sources of liquidity (e.g., increasing deposits or decreasing loans) exceed uses of liquidity (e.g., 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.

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 DepositsEstimated Total Loans

$112$87

13295

121102

147113

151101

139124

Change in DepositsChange in LoansEstimated Liquidity

Deficit or Surplus

$ ---$ ---$ ---

+20+8+12

-11+7-18

+26+11+15

+4-12+16

-12+23-35

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

11-10. What steps are needed to carry out the structure of funds approach to liquidity management?

In the first step, the institution's deposits and other funds sources are divided into categories based upon their estimated probability of being withdrawn and, therefore, lost to the financial firm. Second, the liquidity manager must set aside liquid funds according to some desired operating rules for those categories. Categories can include "hot money" liabilities, vulnerable funds, and stable funds.

11-11.Suppose that a thrift institutions 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 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 stand at $117 million, but have recently reached $132 million. If reserve requirements on liabilities currently stand at 3 percent, what is this depository institutions total liquidity requirement?

Total Liquidity Requirement= 0.80($19 million - 0.03 x $19 million)

+ 0.25 ($54 million - 0.03 x $54 million)

+ 0.05 ($112 million - 0.03 x $112 million)

+ ($132 million +O.08 x $132 million - $117 million)

= $58.831 million

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

The liquidity indicator approach uses tell-tale financial ratios (e.g., total loans/total assets or cash assets/total assets) whose changes over time may reflect the changing liquidity position of the financial institution. The 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 todays 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 be calculated from these figures?

(In millions of dollars)AssetsLiabilities

Cash Deposits held atFederal Fund Purchased$ 62

other Banks$ 633

U.S. Government securities$ 185Demand Deposits$ 988

Net Loans and Losses$3,502Time Deposits$2,627

Federal Funds Sold$ 48

Total Assets$4,446

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$4446

Net Federal Funds Position:

(Federal Funds Sold Federal Funds Purchased)=($48 - $62)=- 0.31 percent

Total Assets$4446

Capacity Ratio:

Net Loans and Leases=$3,502=77.77 percent

Total Assets$4446

Deposit Composition Ratio:

Demand Deposits=$988=37.61 percent

Time Deposits$2,627

Liquid Securities Indicator:

U.S. Government Securities=$185=4.16 percent

Total Assets$4446

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 in order.

11-15.What is money position management?

Money position management is the management of a financial institutions 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 managements goal is to ensure that the bank has sufficient legal reserves to meet its reserve requirements as imposed by the central bank. Also make 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 institutions 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 equal the reserve requirement on transaction deposits times the daily average amount of net transaction deposits over a designated period plus the reserve requirement on nontransaction reservable liabilities times the daily average amount of nontransaction reservable liabilities. Currently nontransaction liabilities have a reserve requirement of zero.

11-18.First National Bank finds that its net transactions 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 $43.9-$9.3 million of Transaction Deposits] +

.10*[Amount of Transaction Deposits in Excess of $43.9 million]

= .03 * $34.6 + .10 * ($140 - $43.9)

= $1.038 million + $9.61 million

= $10.648 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 have a legal reserve deficiency? How would you recommend that its management responds to the current situation?

The bank's total required legal reserves must be:

Required Legal Reserves = 0.03 x [First $43.9 $9.3 million of Transactions Deposits] +

0.10 x [Transactions Deposits Over $43.9 million]

= .03*$34.6 + .10*($200 - $43.9)

= $1.038 million + $15.61 million = $16.648 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 is over required reserves by $9,352,000. 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 institutions legal reserve account?

Several factors must be taken into account by the money position manager, including current and expected future levels of interest rates, projected changes in monetary policy, the bank's borrowing capacity and current holdings of liquid assets, the bank's forecast of future deposit growth and loan demand, the expected size and duration of any liquidity deficits or surpluses, and his or her knowledge of the future plans of the bank's largest depositors and borrowers with credit lines.

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

Any financial institution using the Federal Reserve check clearing system has to maintain a minimum balance with the Federal Reserve. The amount is determined by its estimated check clearing needs and its recent record of overdrafts. The clearing balance can be a benefit because the institution earns credits from holding this balance with the Fed and this credit can be used to pay the fees the Fed charges for services.

11-22.Suppose a bank maintains an average clearing balance of $5 million during a period in which the Federal funds rate averages 6 percent. How much would this bank have available in credits at the Federal Reserve Bank in its district to help offset the charges assessed against the bank for using Federal Reserve services?

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

= $5,000,000 x .06 x 14/360 = $11,666.67

11-23.What are sweeps 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 savings accounts which do not carry reserve requirements overnight. This service lowers the banks overall cost of funds while still allowing the customer access to their deposits for payments. These sweep arrangements account for nearly $200 billion in deposit balances today and therefore have significantly reduced the total reserve requirements of banks.

Problems

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

Deposit withdrawals$98 Sales of bank assets40

Deposit inflows 87Stockholder dividend payments150

Scheduled loan repayments 89Revenues from sale of nondeposit services 95

Acceptable loan requests 56Repayments of bank borrowings60

Borrowings from the money market75Operating expenses 45

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

Deposit withdrawals$98-

Deposit inflows$87+

Scheduled loan repayments$89+

Acceptable loan requests$56-

Borrowings from the money market$75+

Sales of bank assets$40+

Stockholder dividend payments$150-

Revenues from sale of nondeposit services$95+

Repayment of bank borrowings$60-

Operating expenses$45-

= + [$87+ $89+ $75+ $40+ $95] - [$98+ $56+ $150+ $60+ $45]

= - $23 million.

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

11-2.Mountain Top Savings is projecting a net liquidity deficit of $5 million next week partially as a result of expected quality loan demand of $24 million, necessary repayments of previous borrowings of $15 million, disbursements to cover operating expenses of $18 million, planned stockholder dividend payments of $5 million, expected deposit inflows of $26 million, revenues from nondeposit service sales of $18 million, scheduled repayment of previously made customer loans of $23 million, asset sales of $10 million, and money market borrowings of $15 million. How much must Mountain Tops expected deposit withdrawals be for the coming week?

Supplies of Liquidity Flowing into the Mountain Top Savings

Expected deposit inflows$26 million

Revenues from nondeposit service sales 18 million

Scheduled repayments of prev.

made customer loans 23 million

Asset sales 10 million

Money market borrowings 15 million

Total Source of Liquidity$92 million

Demands on the Mountain Top Savings for Liquidity

Expected quality loan demand$24 million

Necessary repayments of

previous borrowings 15 million

Disbursements to cover

operating expenses 18 million

Stockholder dividend payments 5 million

Total Uses of Liquidity Excluding

Deposit Withdrawals$62 million

Then Net Liquidity Deficit= Liquidity Supplies - Liquidity Demands - Deposit Withdrawals - $5 million = $92 million - $62 million - Deposit Withdrawals

Therefore, expected deposit withdrawals must equal $35 million for the next week.

11-3.First National Bank of Lawrenceville 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 in below. Use the sources and uses of funds approach to indicate which months are likely to result in liquidity deficits and which in liquidity surpluses if these forecasts turn out to be true. Explain carefully what you would do to deal with each months projected liquidity position.

MonthCheckable

DepositsTime and Savings

DepositsCommercial

LoansConsumer

Loans

January120550650140

February115500650200

March 100500700200

April 90485700150

May105465710150

June 80490700175

July 90525700175

August 100515675175

Solution:

MonthTotal

DepositsChange

from Previous

MonthTotal

LoansChange

from Previous

MonthSourceUseNet

January670----790----

February615-55850+600115-115

March600-15900+50065-65

April575-25850-505025+25

May570- 5860+10019-15

June570 0875+15015-15

July615+4587504515+45

August615+ 0850-25250+25

January-February, February-March, April-May 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, April-May and May-June the bank faces deficits ranging from $15 to $115 million. These deficits can be met by:1. aggressive advertising to attract NOW deposits,

2. issuing negotiable CDs in the money market,

3. if they have a holding company, the holding company could sell commercial paper and pass the proceeds through to the bank subsidiary,

4. borrowing Federal funds,

5. borrowing from the Federal Reserve district bank (although this is not a likely alternative for most banks),

6. selling securities under agreements to repurchase,

7. selling some of their loans,

8. selling some of their securities, or

9. a combination of a number of these alternatives.

March-April, June-July, and July-August the bank faces anticipated surpluses ranging from $25 to $45 million. These surpluses afford the bank the opportunity to:

1. aggressively pursue new loans,

2. invest in various money market instruments, such as Treasury securities, or,3. a combination of these alternatives.

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

11-4.King Savings is attempting to determine its liquidity requirements today (the last day of 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 75 percent reserve in liquid assets or borrowing capacity for each dollar of hot money deposits, a 20 percent reserve behind vulnerable deposits and a 5 percent reserve for its holdings of core funds. Assume time and savings deposits carry a zero percent reserve requirement and all checkable deposits carry a 3 percent reserve requirement. King currently has total loans outstanding of $2,389 million, which two weeks ago were as high as $2,567 million. Its loans mean annual growth over the past three years has been about 8 percent. Carefully prepare low and high estimates for Kings total liquidity requirement for September.

Millions of DollarsCheckable DepositsSavings DepositsTime Deposits

Hot money funds$10 $____$782

Vulnerable funds 22152540

Stable (core) funds 30285172

SourceCheckable

depositsSavings

depositsNonpersonal

time depositsTotals

Hot money funds$10----782792

Vulnerable funds22152540714

Stable (core) funds$30285172487

Totals624371,4941,993

Deposit Liquidity Requirement = 0.75 [Net "Hot Money" Funds] + 0.20 [Net Vulnerable Funds]

+ 0.05 [Net "Core" Funds]

a) Net Hot Money Funds = [$10 million - ($10 million * 0.03)] + [$0 million] + [$782 million]

= $9.7 + $0 + $782 = $791.7 million (b) Net Vulnerable Funds = [$22 million - ($22 million * 0.03)] + [$152 million] + [$540 million]

= $21.34 + $152 + $540 = $713.34 million (c) Net Core Funds = [$30 million - ($30 million * 0.03)] + [$285 million] + [$172 million]

= $29.1 + $285 + $172 = $486.1 million Therefore, deposit liquidity requirement = 0.75 [$791.7] + 0.20 [$713.34] + 0.05 [$486.1]

= $593.775 + $142.668 + $24.305 = $760.748 million OR $761 millionTotal liquidity requirement = additional loan demand + deposit liquidity requirement

Recent experience: Currently, loans total $2,389 million, but recently have been as high as $2,567 million, or an additional $178 million.

Historically (based on past three years), loan growth has averaged 8 percent annually.

Anticipated additional loan demand (low estimate) = $2,389 * 1.08 = $2,580

Anticipated additional loan demand (high estimate) = $2,567 * 1.08 = $2,772

Therefore, additional loan demand could range from $191 million to as much as $383(2772-2389) million.

Total liquidity requirement (low estimate) = $761 + $191 = $952 million.

Total liquidity requirement (high estimate) = $761 + $383 = $1,144 million.

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

Most recent yearPrevious year

Assets:

Cash and due from depository institutions$345000$358,000

U.S. Treasury securities$176,000$178,000

Other securities$339,000$343,000

Pledged securities$287,000$223,000

Federal funds sold and reverse repurchase agreements$175,000$131,000

Loans and leases net$2,148,000$1,948,000

Total Assets$3,200,000$3,001,000

Liabilities:

Demand deposits$500,000$456,000

Savings deposits$730,000$721,000

Time deposits$1,100,000$853,000

Total deposits$2,430,000$2,130,000

Core deposits$850,000$644,000

Brokered deposits$58,000$37,000

Federal funds purchased and repurchase agreements$217,000$237,000

Other money market borrowings$25,000$16,000

Cash and due from depository institutions$345,000$358,000

U.S. Treasury securities$176,000$178,000

Other securities$339,000$343,000

Pledged securities$287,000$223,000

Federal funds sold and reverse repurchase agreements$175,000$131,000

Loans and leases Net$2,148,000$1,948,000

Total Assets$3,200,000$3,001,000

Liabilities:

Demand deposits$500,000$456,000

Savings deposits$730,000$721,000

Time deposits$1,100,000$853,000

Total deposits$2,430,000$2,130,000

Core deposits$850,000$644,000

Brokered deposits$58,000$37,000

Federal funds purchased and repurchase agreements$217,000$237,000

Other money market borrowings$25,000$16,000

Most Recent Year

Previous YearCash position indicator:

345,000/3,200,000

358,000/3,001,000

Cash and due from banks/Total assets = .1078

= .1193Liquid securities indicator:

176,000/3,200,000

178,000/3,001,000

U.S. Govt. sec. / Total assets

=.055

=.0593Net federal funds position: (175,000-217,000)/3,200,000 (131,000-237,000)/3,001,000

(Fed funds sold-Fed funds purchased) =-.0131

=-.0353 /Total Assets

Capacity ratio:

2,148,000/3,200,000

1,948,000/3,001,000

Net loans and leases/Total assets

=.6713

=.6491Pledged security ratio:

287,000/515,000

223,000/521,000

Pledged securities/Total securities

=.557

=.428Hot Money Ratio:

345,000+176,000+175,000 358,000+178,000+131,000Money mkt assets*/Volatile liabilities 217,000 + 25,000 237,000 + 16,000

Cash, U.S. Govt Sec., Fed Funds Sold=2.88 X =2.64 X

Deposit brokerage index

58,000/2,430,000

37,000/2,130,000

Brokered deposits/Total deposits

=.0239

=.0174Deposit Composition Ratio

500,000/1,100,000

456,000/853,000

Demand deposits/Time deposits

=.4545

=.5346

Core deposit ratio

850,000/3,200,000

644,000/3,001,000

Core deposits/Total assets

=.2656

=.2146

Watson appears to have mixed liquidity trends, though most indicators reflect declining liquidity. Cash assets are falling relative to total assets, though holdings of U.S. Government securities are rising relative to total assets. 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 and, therefore, are not available for liquidity needs. Another area of concern that needs management's attention is the near tripling in the 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:AssetsLiabilities and Equity

Cash$100Deposits$4000

Securities1,000Other liabilities500

Loans4,000Equity600

Total assets5,100Total Liabilities and equity5100

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

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

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. 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 the Bank of Your Dreams?

b. If liability management is used to provide funds for the loans, what happens to the size of the 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 Victoria Savings Bank's liquidity manager estimates that the bank will experience a $375 million liquidity deficit next month with a probability of 10 percent, a $200 million liquidity deficit with a probability of 40 percent, a $100 million liquidity surplus with a probability of 30 percent, and a $250 million liquidity surplus bearing a probability of 20 percent. What is this savings banks expected liquidity requirement? What should management do?

Liquidity Deficits or

SurplusesAssociated

Probabilities

-$375 million10%

-$200 million40

+$100 million30

+$250 million20

100%

The bank's expected liquidity requirement is:

Expected Liquidity Requirement = 0.10 *(-$375 million) + 0.40 * (-$200 million) +

0.30* (+$100 million) + 0.20 * (+$250 million)

= -$37.5 million - $80 million + $30 million + $50 million

= -$37.5 million

Faced with a 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 transactions 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 $0.95 million over the vault-cash computation period. Assuming that reserve requirements on transaction deposits are 3 percent for deposits over $9.3 million and up to $43.9 million and 10 percent for all transaction deposits over $43.9 million while time deposits carry a 3 percent required reserve, calculate this savings institutions required daily average reserve at the Federal Reserve Bank in the district.

Daily required reserves at Fed= [($43.9-9.3)*0.03] + [($75 $43.9)*.10] + [$37 * 0.03] -$0.95 = $1.038 + $3.11 + $1.11 - $0.95 = $5.258- $0.95 = $4.308 million

11-10. Elton Harbor Bank has a cumulative legal reserve deficit of $44 million at the Federal Reserve bank in the district 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 InstrumentCurrent Market Yield

Federal funds 1.98%

Borrowing from the central banks discount window2.25

Commercial paper (one-month maturity)2.33

Banker's acceptances (three-month maturity)2.30

Certificates of deposit (one-month maturity)2.52

Eurodollar deposits (three-month maturity)3.00

U.S. Treasury bills (three-month maturity)1.85

U.S. Treasury notes and bonds (1-year maturity)2.57

U.S. Treasury notes and bonds (5-year maturity)3.65

U.S. Treasury notes and bonds (10-year maturity)4.19

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

The array of interest rates given in this problem suggests a number of ways Elton Harbor Bank could meet its reserve requirements. Federal funds borrowing currently is relatively cheaper than 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 compare to other source at 2.25 percent, except that it has just repaid a Fed loan and may have borrowed recently. It would be good if a CD customer or a Treasury bills (three-month maturity) could be found to supply a total of $40+ million. 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.Gwynns Island Building and Loan Association estimates the following information regarding this institutions reserve position at the Federal Reserve for the reserve maintenance period that begins today (Thursday):

Calculated required daily average balance at the Federal Reserve Bank = $760 million

A loan received by the Fed's discount window a week ago that comes due on Friday (day 9)

= $ 70 million

Planned purchases of U.S. Treasury securities on behalf

of the association and its customers:

Tomorrow (Friday)

= $ 80 million

Next Wednesday (day 7)

= $ 35 million

Next Friday (day 9)

= $ 18 million

Gwynns 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 Reserves discount window as tools to manage its reserve position, carefully construct a pro forma daily worksheet for this associations 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 Gwynns Islands reserve position and hit your desired reserve target.Check clearing estimates over the next 14 days are as follows:

DayCredit Balance

in Millions (+)Debit Balance

in Millions (-)

1+10

2-60

3Closed

4Closed

5-40

6-25

7+30

8-45

9-5

10Closed

11Closed

12+20

13-70

14+10

DayEst. Daily

Avg

Res. Bal.

ReqCheck

Clear-ingsFederal

Funds

Trans.

Purchases (+)

Sales ((-)Federal

Discount

Window

Borrow (+)

Repay(-)Treas.

Sec.

Red. (+)

Purch (-)Clos-ing

Daily

Avg.

Bal.Excess or

Deficit

in Legal

Res.Cum.

Exc.

or

Def.Cum.Closing

Res.

Bal.

at Fed.

Deficit from Previous Period - $5 mill

1 (Thurs)$760+10$765+5+5765

2 (Fri)$760-60+205-8083070751595

3 (Sat)$760830701452425

4 (Sun)$760830702153255

5 (Mon)$760-40-205585-175403840

6 (Tues)$760-25560-200-1604400

7 (Weds)$760+30-35555-205-3654955

8 (Thurs)$760-45510-250-6155465

9 (Fri)$760-5+300+230-181017+257-3586482

10 (Sat)$7601017+257-1017499

11 (Sun)$7601017+257+1568516

12 (Mon)$760+20-300737-23+1339253

13 (Tues)$760-70667-93+409920

14 (Wed)$760+10+43720-40010,640

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

11-12.Lathrop 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

= $ 87,457,350

Nonpersonal time deposits under

18 months to maturity

= $168,943,580

Eurocurrency liabilities

= $ 7,340,210

Daily average balance in vault cash= $ 1,500,075.

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

Net transaction accounts:

$9.3 to $43.9 million

3%

More than $43.9 million

10%

Nonpersonal time deposits:

Less than 18 months

3%

18 months or more

0%

Eurocurrency liabilities-all types 3%

What is this savings bank's total 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: [($43.9 million-9.3 million) * 0.03] + [($87,457,350 - $43.9 million) * 0.10]

+ [($168,943,580 + $7,340,210) * 0.03]

= $1,038,000 + $4,355,735 + $5,288,514 = $10,682,249Daily average reserve holdings: $10,682,249 - $1,500,075 = $9,182,174

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 Streets 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 = 0.03 * ($43.9 - $9.3) + 0.10 * ($150 $43.9)

= $1.038 + $10.61

= $11.648 million

11-14Sweetbriar Savings Association maintains a clearing account at the Federal Reserve Bank and agrees to keep a minimum balance of $30 million in its clearing account. Over the two-week reserve maintenance period ending today Sweetbriar managed to keep an average clearing account balance of $33 million. If the Federal funds interest rate has averaged 2.25 percent over this particular maintenance period, what maximum amount would Sweetbriar have available in the form of Federal Reserve credit to help offset any fees the Federal Reserve might charge this association for using Federal Reserve services?

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

= $33,000,000 * 0.0225 * 14 days/360 days

= $28,875PAGE 11-2

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