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Chapter: 11
Liquidity & Reserve
Management
Strategies & Policies
1
Supplies of Liquidity Flowing into Banks.
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Incoming deposits.
Revenues from the sale of nondeposit
services.
Customer loan repayments.
Sales of bank assets.
Borrowings from the money market.
2
Demands on the Bank for Liquidity

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Deposits withdrawals.
Volume of acceptable loan requests.
Repayment of bank borrowings.
Other operating expenses.
Dividend payments to bank stockholders.
3
Net Liquidity Position (Lt)

The difference between the total supply of
liquidity flowing into a bank & the demands
made upon the bank for liquidity. The most
pressing demands for spendable funds
come from two sources:
1. Customers withdrawing money
deposit.
2. Credit requests from customers.
from
their
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Implications of Liquidity Management


Rarely are the the demands for bank liquidity equal to
the supply of liquidity at any particular point of time.
There is a trade-off between bank liquidity &
profitability. High degree of liquidity will reduce the
bank’s expected profitability.
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Why banks face significant liquidity
problem?

Imbalance between the maturity dates on their assets
& the maturity dates attached with their liabilities, i.e,
high proportion of demand deposit & high proportion
of long-term lending.
 Sensitivity to changes of interest rates. If other banks
offer high interest rate, some customer will withdraw
their funds for better returns elsewhere.
 Bank’s attitude towards lending & providing services
to the depositors.
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Strategies for Liquidity Managers
1.
2.
3.
Providing liquidity from assets (Asset
Liquidity Management).
Relying on borrowed liquidity to meet cash
demands (Liability Management).
Balanced Liquidity Management (Asset &
Liability).
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1) Asset Liquidity Management Strategies

Reliance on liquid assets that can be readily sold for
cash to meet a bank’s liquidity needs. A liquid asset
must have three characteristics:
– Ready Market.
– Stable Price.
– Reversible.

This strategy is used mainly by small banks that find
it a less risky approach than relying on borrowings.
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Implications of Asset Liquidity Management
Strategies
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Selling assets means the bank loses the future
earnings possibility.
Selling assets involve transaction cost paid to the
security brokers.
Asset in question may need to be sold in a market
experiencing declining prices. (capital loss possibility)
Selling assets tends to weaken the appearance of the
bank’s balance sheet.
Liquid assets generally holds lowest rate of return,i.e,
by investing in liquid assets, banks are ignoring the
possibility of higher return on other financial assets.
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2)Borrowed Liquidity Management Strategies

Reliance upon borrowed funds to meet a bank’s liquidity
needs. The sources of borrowed funds:
 Federal funds borrowing.
 Repos.
 Issuing large negotiable CDs to major corporation, government
& wealth individuals.
 Issuing Eurocurrency deposits.
 Borrowing reserves from the discount of the central bank.

This is the most risky approach to solving liquidity
problems because of the volatility of money market
interest rates & the rapidity with which the availability of
credit can change.
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3) Balanced Liquidity Management Strategies

The combined use of liquid asset holdings &
borrowed liquidity to meet a bank’s liquidity needs.
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Estimating A Bank’s Liquidity Needs

Three approaches in measuring
estimating a bank’s liquidity needs:
or
1. The sources & uses of fund approach.
2. The structure of funds approach.
3. Liquidity indicator approach.
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1) The Sources & Uses of fund approach.

A method for estimating a bank’s liquidity requirements by
focusing primarily on expected changes in deposits &
loans. The approach begins with two simple facts:
 Bank liquidity rises as deposits increase & loans decrease.
 Bank liquidity declines when deposits decrease & loans
increase.

Estimated liquidity deficit (-) or surplus (+) for the coming
period = estimated changes in total deposits (D) –
estimated change in total loans (L)
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2) The Structure of Funds Approach

A method for estimating a bank’s liquidity needs by
dividing its borrowed funds into categories based upon
their probability of withdrawal. The categories are:
1.
2.
3.
“Hot Money Liabilities”: Deposits & Non Deposit Borrowed
funds that are very interest sensitive & will be withdrawn
during the current period.
Vulnerable Funds: Customer deposits of which a
substantial portion (25%-30%) will probably be removed
during the current period.
Stable Funds: Most unlikely to be removed during the
current period.
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The Structure of Funds Approach…contd.

Total Liquidity Requirement for a Bank = 0.95
X (Hot money funds – legal reserves held) +
0.30 X (Vulnerable deposits – legal reserves
held) + 0.15 X (Stable deposits – legal
reserves held) + 1.00 X (Potential loans
outstanding – Actual Loans outstanding)
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3) Liquidity Indicator Approach
1.
2.
3.
4.
5.
6.
Cash position indicator = cash & deposits due from
depository institutions / total assets.
Liquid securities indicator = government securities / total
assets.
Net federal funds position = federal funds sold – federal
funds purchased/ total asset
Capacity ratio = net loans & leases / total assets.
Pledged securities ratio = pledged securities / total
securities holdings.
Hot money ratio = money market assets / money market
liabilities.
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Liquidity Indicator Approach…contd.
7.
8.
9.
10.

Deposit brokerage index = brokered deposits / total
deposits.
Core deposit ratio = core deposits / total assets.
Deposit composition ratio = demand deposits / time
deposits.
Loan Commitment Ratio= Unused loan Commitments/
Total Assets
These indicators are highly sensitive to the season of
the year & the stage of the business cycle. Liquidity
indicator often decline at boom period due to high loan
demand & vice versa.
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Legal Reserves & Money Position Management

Legal reserves are the assets that a central bank requires
depository institutions to hold as a reserve behind their
deposits or other liabilities.

Total required legal reserves = {reserve requirements on
transaction deposits X daily average amount of net
transaction deposits over a designated period} + {reserve
requirements on nontransaction reservable liabilities X
daily average amount of nontransaction reservable
liabilities }
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