Liquidity and Reserve Management Strategies

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Liquidity and Reserve Management Strategies

• Banks are faced with the task of maintaining
  adequate liquidity at all times.
• A bank is said to be liquid if it has ready
  access to immediately spendable funds, at
  reasonable cost, at precisely the time those
  funds are needed.
• Illiquidity is often a first sign of insolvency.
• A banks need for liquidity is determined by the
  difference between its sources of liquidity
  (supply) and demand for liquidity.
• The net liquidity position (L) of a bank at any
  particular time period can be defined as

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Liquidity Management Strategies

• There are three basic liquidity management
  strategies asset liquidity management, borrowed
  (liability) liquidity management, and balanced
  (asset and liability) liquidity management.
• Asset Liquidity management (or Asset Conversion)
  Strategy
• - it a technique of storing liquidity in the
  form of assets (in cash or marketable securities.
• - Such liquid assets must have ready market
  (such that they are easily convertible to cash),
  have stable price (must not be subject to
  significant price decline), and must be
  reversible.
• Asset conversion strategy involves opportunity
  cost.
• The strategy also results in lower earnings

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• Borrowed Liquidity (Liability) Management
  Strategy
• - This strategy is also known as purchased
  liquidity and it involves borrowing from money
  market to offset liquidity need.
• - Banks can choose to borrow funds from
  Federal funds, repos, reserves from central
  banks, issuing negotiable CDs, etc.
• - This approach is the most risk approach to
  liquidity management.
• Balanced Liquidity Management Strategy
• - This strategy combines the use of asset
  conversion and borrowed liquidity approaches.
• - It is the best liquidity management
  strategy.

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Estimating Liquidity Needs

• Banks and other financial institutions attempt to
  forecast their liquidity needs using several
  approaches.
• Though liquidity needs may not be accurately
  estimated, it provides banks opportunity to be
  able to meet the needs.
• Liquidity estimate enables banks to have
  liquidity reserves made up of planned and
  protective components.
• Liquidity needs estimation techniques include
  the sources and uses of funds approach, the
  structure of funds approach, the liquidity
  indicator approach, and the market signals (or
  discipline) approach.

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• The Sources and Uses of Funds Approach this
  approach is based on existence of liquidity gap
  between sources and uses of funds
• - there are three steps involved in the uses of
  the sources and uses of funds approach.
• Forecast of loans and deposits for a given
  liquidity planning period
• Calculate the estimated change in loans and
  deposits for the same period.
• Estimate the net liquidity funds surplus or
  deficit for the planning period by comparing the
  estimated change in loans (or order uses of
  funds) to the estimated change in deposits (or
  other sources of funds).
• Estimated change in loans can be derived as
• ?Loanst f(? GDPt, Et, ?MSt, iL-icp, ?)
  (6)
• Where ? growth rate/percentage change E
  estimated earnings MS money supply, iL prime
  loan rate icp commercial paper rate, ?
  inflation rate

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• Estimated change in total deposits can be derived
  as
• ?Depositt f(?YP, Salest, ?MSt, iytmmd, ?)
  (7)
• Where ? growth rate/percentage change Sales
  estimated retail sales MS money supply, iyt
  yield on money market deposit ? inflation
  rate.
• The forecast loans and deposits above are used to
  estimate the liquidity needs of banks.
• Estimated liquidity Estimated
  Estimated
• deficit (-) or surplus () change in
  - change in (8)
• For the coming period deposits
  loans
• The sources and uses of funds approach can also
  be used to estimate liquidity needs through trend
  analysis. This divides forecast deposit and loans
  into trend, seasonal and cyclical components.

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• ii. The Structure of Funds Approach this
  approach involves thre steps. first divides
  deposits and other funds sources into different
  categories depending on the probability of
  withdrawals. These categories are usually
• Hot Money liabilities (volatile liabilities)
  high interest sensitive deposits and borrowed
  funds that expected to be withdrawn in current
  period.
• Vulnerable funds customer deposits of
  substantial portion is likely to be withdrawn in
  current period.
• Stable funds (core deposits/liabilities) funds
  that are not likely to be withdrawn.
• Second step is the allocation of liquid funds
  for each category of funds according to some
  operating rules. For example,

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• Liability liquidity reserve 0.95 x (Hot money
  funds funds Legal reserves) 0.30 x
  (Vulnerable funds Legal reserves)
  0.15 x (Stable funds Legal
  reserves) (9)
• The third step is to estimate the total
  liquidity requirement for the bank.
• Total liquidity requirement 0.95 x (Hot
  money funds funds Legal reserves)
  0.30 x (Vulnerable funds Legal
  reserves) 0.15 x (Stable funds Legal
  reserves) Potential loans x loans
  growth (Potential loans Actual
  loans) (10)

Deposit and nondeposit liability liquidity
requirement and loan liquidity requiremnt
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• iii. Liquidity Indicator approach this
  approach estimate liquidity needs by relying on
  the use of experience and industry averages.
  This approach uses different liquidity indicators
  ratios such as
• Cash position indicator cash and deposits due
  from depository institutions ? total assets.
• Liquid security indicator Government
  securities ? total assets
• Net federal (central bank) funds and repurchase
  agreements position (federal funds sold and
  reverse repurchase agreements federal funds
  purchased and repurchase agreements) ? total
  assets.
• Capacity ratio Net loans and leases ? total
  assets.
• Pledge security ratio Pledge securities ? total
  security holds
• Hot money ratio Money market (short-term) assets
  ? volatile liabilities (cash and dues from
  deposits held at other depository institutions
  holdings of short-term securities federal funds
  loans reverse repurchase agreements) ? (large
  CDs Eurocurrency deposits federal funds
  borrowed repurchase agreements).
• Deposit composition ratio Demand deposits ? time
  deposits
• Loan commitment ratio Unused loan commitments ?
  total assets.

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• iv. Market signal (discipline) approach this
  is a qualitative approach to measuring liquidity
  requirement of banks. It is technique that
  centres on the discipline of the financial market
  place, which subject banks to series of markets
  tests, such as the ability of bank to pass the
  following tests
• Public confidence
• Stock price behaviour
• Risk premium on CDs and other borrowings
• Loss sales of assets
• Meeting commitments to credit customers
• Borrowings from the central bank.