Chapter 11
Managing Liquidity
Chapter Objectives
1. Describe the relationships between cash holdings and liquidity requirements.
2. Demonstrate the requirements for meeting legal reserves.
3. Explain the impact of sweep accounts on legal reserves at banks.
4. Describe procedures and problems in clearing checks and managing float.
5. Examine the strengths and weaknesses of traditional balance sheet measures of liquidity.
6. Introduce liquidity planning models for the reserve maintenance period and longer periods.
7. Construct liquidity measures which indicate a funding surplus or need.
8. Introduce the need to have a contingency plan for funding.
Key Concepts
1. Cash assets, such as value cash, demand balances held at Federal Reserve Banks, demand
balances held at other financial institutions, and CIPC, produce no interest income. Banks
prefer to hold as few cash assets as possible, yet still meet payments and service
requirements.
2. In July 1998, the Federal Reserve moved back to lagged reserve account (LRA). In this
system, banks hold legal reserves that are determined primarily by their deposit liabilities that
are outstanding over a prior two-week period.
3. Many banks sweep customer funds from deposit accounts that are subject to a 10% legal
reserve requirement into MMDA accounts that are not subject to legal reserves. The sweep
has the effect of removing the 10% reserve requirement against certain deposit accounts.
Since mid -1995, banks have sharply increased the volume of sweep accounts such that the
Federal Reserve has less direct control over bank deposits in the aggregate.
4. It used to take several days for a check to clear as the item was transferred between financial
institutions. Banks thus placed “holds” on checks that specified how long a customer had to
wait before spending the proceeds of a deposit. In 2004 the U.S. Congress passed Check 21
legislation, which effectively eliminates float, or checks in process of collection, for most
transactions. Customers will generally pay fees if they write checks against funds they don’t
have on deposit when they write the check.
5. Banks hold correspondent balances as payment for services obtained from another financial
institution. Minimum balances are based on an estimate of the cost of services provided and
the correspondent bank’s average interest yield from investing available balances.
6. Bank liquidity needs arise from net deposit outflows. Unanticipated loan demand and deposit
withdrawals force banks to position their portfolios to provide quick access to cash.
7. The more liquid a bank is, the lower is its profitability as measured by ROE and ROA.
8. Banks frequently experience deposit losses after market participants perceive that the bank has
assumed too much credit risk, interest rate risk, or foreign exchange risk.
9. Banks can partially meet liquidity needs by holding liquid assets, such as short-term, unpledged
marketable securities with low default risk.
10. Liability liquidity represents a bank’s ability to access cash via new borrowing and is closely tied to a
banks capital position and asset quality.
11. Liquidity planning during the 2-week reserve maintenance period focuses on projecting the reserves
impact of discretionary and nondiscretionary transactions that alter reserve assets.
12. Liquidity planning beyond 2 weeks analyzes loan and deposit growth in terms of trend, seasonal, and
cyclical components in order to predict net deposit outflows, which are then compared with potential
sources of funds. This contingency planning helps prevent crises.
13. Liquidity gap analysis compares uses of funds (cash outflows) with sources of funds (cash inflows)
over different time buckets. The difference equals a liquidity gap. If the liquidity gap is positive, the
bank needs to obtain additional funding as cash outflows are expected to exceed cash inflows over the
period. A negative liquidity gap indicates that the bank expects to invest excess funds over the period.
14. Financial institutions must have carefully designed contingency plans that address their strategies for
handling unexpected liquidity crises and outline the appropriate procedures for dealing with liquidity
shortfalls occurring under abnormal conditions.
Teaching Suggestions
This chapter should extend students’ understanding of a bank’s legal reserves as applied to
individual banks. Reserve requirements are typically discussed in the aggregate for all banks in a
traditional Money and Banking class. The mechanics of the process require new interpretations of
the terms total reserves and excess reserves. Because of the averaging process over a 14-day
maintenance period, all reserves are excess reserves during the first 13 days because a bank can
make adjustments on the last day of the maintenance period to meet legal requirements applicable
for the entire period.
Discuss the correspondent banking relationship. Many students do not understand why a bank
might have a checking account at another bank. Use the information in the text to discuss the
different types of relationships between banks and how banks pay for any services. This is also a
good time to introduce Bankers Banks, which exist throughout the U.S. These institutions are
owned by member banks and generally provide correspondent banking services that community
banks once purchased from large superregional banks that are now often direct competitors.
Students are often confused regarding the importance of the relationship between liquidity, capital
adequacy, and a bank’s asset quality. It is useful to begin discussion by emphasizing the interrelationships,
particularly the significance of positive equity market value. Distinguish carefully between a bank’s use
of assets for liquidity and a bank’s ability to borrow (liability liquidity). Many banks now use Federal
Home Loan Bank advances as a source of funding and worry less about having assets to sell. In fact, it is
often possible for banks to borrow at lower rates via FHLB advances than by marketing and issuing their
own large CDs. However, many bankers are not careful in the types of advances they use. Today, many
FHLB advances come with options that a bank effectively writes (sells) the FHLB. For example, a
callable advance typically gives the FHLB the option to demand immediate payment of the advance prior
to final maturity, after some deferment period. Not surprisingly, the FHLB will ‘call’ the advance after
interest rates have risen and will give the bank the opportunity to replace the advance with another at
higher rates. This type of borrowing has significant amounts of interest rate risk. Discuss key measures of
asset liquidity and liability liquidity, especially contingency funding plans in the latter case.