INTRODUCTION  The effectiveness depends on:  Banks own five types of liquid assets:

 Funding decisions affect liquidity,  Market conditions  Cash and due from banks and the Federal
profitability and risk by determining the  Market perceptions of bank mgt and strategies Reserve Banks in excess of requirements
stability and quality of the source of  Economic environment  Federal funds sold and reverse repurchase
funding and hence the need for liquidity. agreements
 When the financial crisis hit on 2007, Holding liquid assets  Short term treasury and agency obligations not
many banks in high-growth real estate  Cash assets is a cash in hand. pledged as collateral.
markets often experienced a sharp rise in  Four types of cash assets in financial institutions:  High quality short term corporate and
nonperforming loans (NPL), later  Vault cash municipal securities not pledged as collateral.
followed by liquidity problems.  Demand deposit balances held at Federal Reserve  Some government-guaranteed loans that can
 Liquidity problems occur when the bank Banks be readily sold.
did not have sufficient core deposits or  Demand deposit balances held at private financial
hold enough liquid assets. institutions New borrowing
 Cash item in the process of collection (CIPC)  Financial institutions can access liquid funds by
MEETING LIQUIDITY NEEDS  Cash assets do not satisfy an institution’s liquidity borrowing in the financial markets.
 A financial institution has effectively met needs because they do not cover unanticipated cash  Borrowing is attractive because it can normally be
its liquidity needs when it can acquire requirements. completed quickly and at a predictable price.
sufficient funds quickly and at a reasonable   Bank can issue debt (individuals, pension funds,
cost – either by issuing liabilities or insurance companies) to obtain cash.
liquidating assets. CHAPTER 14
 Financial institutions can borrow when REQUIRED RESERVES AND MONETARY POLICY
investors willingly advance funds because LIQUIDITY MANAGEMENT
 The purpose of required reserves is to
they have confidence that the institutions enable the Federal Reserve to control the
will pay them back in timely manner.
 Banks hold cash assets to satisfy four objectives: nation’s money supply.
 They hold liquid assets to help meet
 Bank supply coin and currency to meet customers’  The Federal Reserve hopes to control credit
potential deposit outflows and
withdrawals of other liabilities and to help regular needs. availability and thereby influence general
fund investments in loans.  Regulatory agencies mandate legal reserve economic conditions.
 Firms can acquire liquidity in three ways: requirements that can be met only by holding  There are three distinct monetary policy
 Selling assets qualifying cash assets. tools:
 New borrowings  Banks serve as a clearing house for the nation’s check-  Open market operations
 New stock issues payment system. - Sale and purchase of government
 However, the most important is how  Banks use cash balances to purchase services from securities.
effective each liquidity source to meet the correspondent banks. - Through the trading, the federal can
institution’s liquidity need. adjust the level of reserves in the
 Since cash assets are not really a source of liquidity for a
 Liquidity sources of funds received from banking system, offset the reserve
financial company, only liquid assets are source of liquidity.
the borrowing and selling of common and requirements, changes in discount
preferred stock.  Liquid assets is one that can be easily and quickly converted
into cash with minimal loss. rate, influence ST interest rate and the
growth of the money supply.
  Discount window  There are: computation period and maintenance LIQUIDITY PLANNING
- Occurs when FIs borrow deposit period.  Banks actively engage in liquidity planning
balances directly from the Federal SUN MON TUES WED THURS FRI SAT at 2 levels.
Reserve. 29 30 1 2 3 4 5  Relates to the management of their ST
6 7 8 9 10 11 12 liquidity needs and required reserve
- Higher interest rate will discourage 13 14 15 16 17 18 19
FIs to borrow. position.
20 21 22 23 24 25 26
- Lower interest rate will make 27 28 29 30 31 1 2  Forecasting net funds needs derived
borrowing less expensive. 3 4 5 6 7 8 9 from seasonal or cyclical phenomena,
10 11 12 13 14 15 16 overall bank growth and contingency
 Changes in reserve requirements
- Directly affect the amount of legal liquidity needs.
CP
required reserves and thus change MP  The planning horizon is considerably
the amount that a FIs can lend. longer, encompassing monthly intervals
- When the fed increases the reserve throughout an entire year.
requirements, it formally increases CHAPTER 14  The liquidity planning consists of:
the requires reserve ratio that  Short-term liquidity planning which
directly reduces the amount a FIs CONTINUED focuses on forecasting closing
can lend. balances at the Federal Reserve. (meet
- Lower reserve requirements, the minimum requirement at lower
CORRESPONDENT BANKING SERVICES cost)
increase liquidity and lending
capacity.  Correspondent banking (downstream  Managing float which refer to bank
- Higher reserve requirements, correspondent) is the system of interbank payment system. It can be made either
decrease liquidity and lending relationships in which one bank sells services to check or electronically.
capacity. other financial institutions.
 The institution that buy the services called as
MEETING THE LEGAL RESERVE REQUIREMENTS respondent banking (upstream correspondent). LIQUIDITY VERSUS PROFITABILITY
 The actual computation of legal reserve  Among of the correspondent banking services are:  There is a short run trade-off between
requirements technically is complex.  Check collection, wire transfer, coin, currency liquidity and profitability.
 Specifically, not all deposits are subjected to reserves supply  The more liquid an institution is, the lower
and following certain method known as Lagged  Loan participation assistance are its return on equity and return on
Reserve Accounting (LRA).  Data processing services assets.
 This system requires banks to hold reserves against  Portfolio analysis and investment advice  Asset liquidity is influenced by quality,
outstanding deposit balances from 3-5 weeks earlier.  Federal funds trading composition and maturity of funds.
 However, LRA reduces the federal ability to control  Securities safekeeping  Liability liquidity refer to institutions best
the money supply and may increase the volatility of  Arrangement of purchase or sale of securities asset quality and highest equity capital.
interest rates.  Investment banking services, swaps, futures, This indicate greater access to purchased
mergers and acquisition.
 Under the LRA procedure, the are 2 methods in funds and can acquire these funds
 Loans to directors and officers cheaper with lower interest rate.
computing the reserve balance requirement.
 International financial transaction
THE RELATIONSHIP BETWEEN LIQUIDITY,  Basel III and liquidity Coverage Ratio which proposed
CREDIT RISK AND INTEREST RATE RISK. banks to meet minimum liquidity requirement linked
 A well-managed institution monitors its to holding of liquid assets.
cash position carefully and maintains low-  LCR objective is to improve large organizations’
liquidity risk. liquidity risk mgt.
 Liquidity risk for poorly managed bank
closely follow credit and interest rate risk.
LONGER TERM LIQUIDITY PLANNING
Whereby, for a bank that experience large
 Longer term liquidity planning refers to more
deposit outflows can often trace the
than 30 days planning.
source to either credit problems or
 All banks regardless of size, project cash inflows
earning declines from interest rate
and outflows over 90 days, 180 days, one year,
gambles that backfired.
and even beyond.
 Liquidity planning forces mgt to monitor
 The objective is to ensure that the bank does
overall risk position such that credit risk
not face an unanticipated liquidity crisis.
partially offsets interest rate risk assumed.
 Potential liquidity needs must reflect
estimates of new loan demand and
potential deposit losses.

TRADITIONAL AGGREGATE MEASURES OF

LIQUIDITY RISK CHAPTER 14
 Traditional liquidity measures focus on balance CONTINUED
sheet accounts and measure liquidity in term of
financial ratios.
 Asset liquidity measure through cash, loans, and
repurchase agreement.
 Liability liquidity measure through following
ratio:
 Total equity to total assets
 Loans to deposits
 Loan losses to net loans
 Reserve for loan losses to net loans
 The % composition of deposits
 Total deposits to TA
 Core deposits to TA
 Federal funds purchased and RPs TA
 Commercial paper & other ST borrowings to
TA