Chapter,Liability and Liquidity Management,18,Overview,Depository institutions and life insurance companies are highly exposed to liquidity risk. This chapter discusses how these firms can control liquidity risk, the motives for holding liquid assets, and specific issues associated with liability and liquidity risk management.,A common definition of liquidity emphasizes the ease of converting an asset to cash with minimum loss.,For a financial institution that regularly borrows in the financial markets, liquidity takes on the added dimension of the ability to borrow funds at minimum cost or even the ability to issue stock. It explicitly recognizes that such firms can access cash by selling assets, by new borrowing, and by new stock issues. Bank liquidity thus refers to a banks capacity to acquire immediately available funds at a reasonable price.,The link between liquidity and banking risks and returns,Liquidity needs arise from net deposit outflows, as balances held with Federal Reserve Banks or correspondent banks decline.Most withdrawals are predictable because they are either contractually based or follow well defined patterns.Still, some outflows are totally unexpected.Management often does not know whether customers will reinvest maturing CDs and keep the funds with the bank or withdraw them.,The relationship between cash and liquidity requirements,The amount of cash held is heavily influenced by the banks liquidity requirements.Vault cash is held to meet reserve requirements and transactions purposes,Cash versus liquid assets,Banks own four types of cash assets: 1. vault cash, 2. demand deposit balances at Federal Reserve Banks, 3. demand deposit balances at private financial institutions, and 4. cash items in the process of collection (CIPC).Cash assets do not earn any interest, so the entire allocation of funds represents a substantial opportunity cost for banks.Banks attempt to minimize the amount of cash assets held and hold only those required by law or for operational needs.,Why do banks hold cash assets?,1. Banks supply coin and currency to meet customers regular transactions needs. 2. Regulatory agencies mandate legal reserve requirements that can only be met by holding qualifying cash assets. 3. Banks serve as a clearinghouse for the nations check payment system. 4. Banks use cash balances to purchase services from correspondent banks.,Liquid assets,A liquid asset is one that can be easily and quickly converted into cash with minimum loss.Contrary to popular notion “cash assets“ do not generally satisfy a banks liquidity needs.If, for example, the bank experiences an unexpected drain on vault cash, the bank must immediately replace the cash or it would have less vault cash than required for legal or operational needs.,Cash assets are liquid assets only to the extent that a bank holds more than the minimum required.,Liquid assets are generally considered to be: 1. cash and due from banks in excess of requirements, 2. federal funds sold and reverse repurchase agreements, 3. short-term Treasury and agency obligations, 4. high quality short-term corporate and municipal securities, and 5. some government-guaranteed loans that can be readily sold.,Reserve balances at the Federal Reserve Bank,Banks hold deposits at the Federal Reserve in part because the Federal Reserve imposes legal reserve requirements and deposit balances qualify as legal reserves.Banks also hold deposits to help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions.Deposit flows are the link between a banks cash position and its liquidity requirements.,Required reserves and monetary policy,The purpose of required reserves is to enable the Federal Reserve to control the nations money supply.There are basically three distinct monetary policy tools: 1. open market operations, 2. changes in the discount rate, and 3. changes in the required reserve ratio.,Changes in reserve requirements,Changes in reserve requirements directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out.For example, a required reserve ratio of 10% means that a bank with $100 in demand deposit liabilities outstanding must hold $10 in legal required reserves in support of the DDAs.The bank can thus lend only 90 percent of its DDAs.,Required reserves,Legal reserves = vault cash and deposits at the Federal Reserve Bank.What determines required reserves?RR = rdd x DD + rtd x TDactually today, rtd = 0Why are required reserves so important?Recall that money (M1) is:M1 = Cash non bank public + DD andDD = Reserves / rdd the money multiplier.,Meeting legal reserve requirements,Required reserves can be met over a two week period.Reserves must be held to a fraction of its base liabilities.There are three elements of required reserves: 1. the dollar magnitude of base liabilities, 2. the required reserve fraction, and 3. the dollar magnitude of qualifying cash assets.,