Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 5. Liquidity and Reserves Management

Presented by: Sudhanshu

Module 1. Net Liquidity and Strategies

Module 2. Bank Liquidity Needs

Module 3. Legal Reserves

Module 1. Net Liquidity and Strategies

Topic 1. Liquidity and its Sources

Topic 2. Liquidity Management Challenges and Risks

Topic 3. Liability (Borrowed Liquidity) Management

Topic 4. Balanced Liquidity Management

Topic 1. Liquidity and its Sources

• Liquidity Definition: A financial institution's access to funds that are immediately spendable, available at low cost, and accessible exactly when needed
• Critical Importance: Lack of liquidity signals financial difficulty and destroys public confidence, making liquidity management essential at all times
• Primary Demand Sources: Credit requests from customers (credit line draws, loan requests) & customer withdrawals from accounts; also includes payoffs of borrowings, dividend payments, and tax payments
• Primary Supply Sources: New customer deposits, customer loan repayments, asset sales, money market borrowings, and fee income from non-deposit services
• Net Liquidity Position (L): Calculated as the difference between liquidity supplies and demands;
  • net liquidity position (L) = supplies of liquidity - demands for liquidity
    • where:
      • supplies of liquidity = incoming deposits (inflows) + customer loan repayments + asset sales + revenue from non-deposit services + money market borrowings
      • demands for liquidity = deposit withdrawals (outflows) + borrowing repayments + dividend payments + loan requests + other operating expenses
  • when L < 0 there is a deficit requiring additional funds, when L > 0 there is a surplus for investment
• Liquidity-Profitability Trade-off: Supply and demand are rarely aligned, causing constant shifts between deficit and surplus positions; funding sources that enhance liquidity typically offer very low returns, forcing institutions to balance liquidity needs with profitability goals

• Timing Factor: Some liquidity needs are immediate (e.g., maturing certificates of deposit) while others are longer-term, allowing institutions to access funds from a wider range of sources

• Cascading Effects: When customers face liquidity problems, these often transfer to the institutions supplying them with liquidity, creating systemic pressure

• Management Costs: Include transaction costs (time and money) in finding liquid funding sources, interest costs on borrowed funds, and opportunity costs from liquidating assets to meet liquidity needs
• Maturity Imbalances: Short-term borrowings (near-term liabilities) versus long-term lending (longer-term receivables) create structural mismatches in financial institutions
• Associated Risks: Interest rate risk (rates may change unfavorably) and availability risk (liquid funds not available when needed) are prevalent due to maturity mismatches; shifting market rates impact both customer deposit demands and loan requests
• Operational Requirements: Liquidity managers must maintain public confidence while regularly communicating with largest customers to anticipate large withdrawals or credit line draws; market value of assets may fluctuate with interest rates, affecting the institution's ability to generate funds through asset sales

Topic 2. Liquidity Management Challenges and Risks

Practice Questions: Q1

Q1. Genny Richards is the liquidity manager for Legend Bank. In evaluating the bank’s net liquidity position, Richards anticipates the following amounts:

Legend Bank’s net liquidity position is closest to:
A. $2,330,000.
B. $2,445,000.
C. $3,385,000.
D. $3,405,000.

Practice Questions: Q1 Answer

Explanation: B is correct.

The net liquidity position is equal to the difference between the supplies of
liquidity and the demand for liquidity. Supplies include asset sales ($1,325,000), incoming deposits ($2,500,000), and non deposit services revenue ($950,000).
Demands include deposit withdrawals ($1,015,000), dividend payments
($470,000), and loan requests ($845,000). The net liquidity position is therefore equal to: ($1,325,000 + $2,500,000 + $950,000) – ($1,015,000 + $470,000 + $845,000) = $2,445,000.

Topic 3. Asset Liquidity Management

• Strategy Overview: A liquidity management approach, often used by smaller financial institutions, that maintains liquidity through holding liquid assets (cash and marketable securities) that are converted into cash as needed to meet liquidity demands

• Liquid Asset Characteristics: Must have a ready market (quickly convertible to cash), relatively stable price (sale doesn't significantly impact price), and reversibility (principal recoverable with little risk of loss)
• Typical Liquid Assets: Treasury bills (U.S. or foreign government obligations), certificates of deposit, municipal bonds, interbank deposits, repurchase agreements, Eurocurrency loans, federal funds loans, and federal agency securities
• Opportunity Costs: Lost earnings on assets sold to create liquidity; assets with lowest profit potential should be sold first, though these assets typically strengthen the firm's balance sheet
• Transaction Costs and Market Risk: Includes costs of executing sales and the risk of selling assets in a declining market when prices are unfavorable
• Safety-Profitability Trade-off: Liquid assets carry lower returns, requiring firms to perpetually balance safety and liquidity needs against profit potential and return objectives

Topic 4. Liability (Borrowed Liquidity) Management

• Strategy Overview: This strategy, commonly used by larger institutions, involves borrowing funds to cover anticipated liquidity demands rather than converting assets

• Key Advantages: Allows institutions to borrow funds only when needed, leaves asset portfolios unaltered compared to asset conversion strategies, and provides flexibility to adjust offered interest rates up or down based on funding requirements
• Primary Funding Sources: Jumbo negotiable CDs ($100,000+), repurchase agreements (liquid security sales), Eurocurrency issuances, federal funds borrowings, central bank discount window borrowings, and advances from Federal Home Loan Banks
• Strategy Risks: Interest rate volatility creates uncertain borrowing costs, credit availability fluctuates unpredictably, making this a risky strategy despite its flexibility and convenience for liquidity management

Topic 5. Balanced Liquidity Management

• Dual Strategy: The majority of financial institutions use both asset and liability management strategies to maintain optimal liquidity positions
• Asset Management Component: Meeting liquidity demands through liquid assets such as marketable securities that can be sold quickly when funds are needed
• Liability Management Component: Establishing advance arrangements for lines of credit from suppliers to ensure access to funding sources
• Balanced Approach: Combining both asset-based liquidity (quick-sale securities) and liability-based liquidity (pre-arranged credit facilities) provides flexibility and reduces dependency on a single funding source
• Time Management Critical: Anticipating upcoming liquidity needs across both short-term and long-term horizons is essential for successful liquidity management
• Success Factors: Effective balanced strategy requires continuous monitoring, proactive planning, and coordination between asset liquidation capabilities and liability funding arrangements

Practice Questions: Q2

Q2. A bank utilizing the liability management strategy is most likely to use which of the following sources of liquidity?
A. U.S. Treasury securities.
B. Federal agency securities.
C. Repurchase agreement sales.
D. Municipal bond investments.

Practice Questions: Q2 Answer

Explanation: C is correct.

Of the choices given, only repurchase agreement sales (sales of liquid securities) would be a component of a liability (borrowed liquidity) management strategy. U.S. Treasury securities, federal agency securities, and municipal bond investments are all components of an asset liquidity management strategy.

Module 2. Bank Liquidity Needs

Topic 1. Liquidity Estimation: Need and Approaches

Topic 2. Sources and Uses of Funds Approach

Topic 3. Structure of Funds Approach

Topic 4. Liquidity Indicator Approach

Topic 5. Market Signals/Discipline Approach

Topic 1. Liquidity Estimation: Need and Approaches

• Continuous Management: Both deficits (requiring quick fund raising) and surpluses (creating opportunity costs from uninvested funds) are problematic and require constant oversight
• Comprehensive Monitoring: Liquidity managers must stay informed of all entity activities involving fund usage and supply; advance knowledge of large account deposits or withdrawals is essential
• Balancing Priorities: Must ensure liquidity management remains a priority while the institution focuses on maximizing returns through service delivery and loan provision
• Liquidity Reserves Structure: Includes a planned component (based on latest forecasts of required reserves) and a protective component (extra cushion above planned reserves based on recent forecasted needs)
• Sources and Uses of Funds Approach: Estimates liquidity by tracking where funds come from and where they are deployed
• Structure of Funds Approach: Analyzes the composition and characteristics of the institution's funding base to assess liquidity position
• Liquidity Indicator Approach: Uses specific financial ratios and metrics to measure and monitor liquidity levels over time
• Market Signals (Discipline) Approach: Relies on market-based indicators and external signals to gauge liquidity conditions and institutional health

Topic 2. Sources and Uses of Funds Approach

Topic 3. Structure of Funds Approach

• Method Overview: Divides funding sources (such as deposits) into three categories based on withdrawal likelihood, with liquid funds set aside according to predetermined operating rules for each category
  • Volatile (Hot Money) Liabilities: Deposits and borrowed funds with high interest rate sensitivity and high probability of withdrawal within the period
  • Vulnerable Funds: Customer deposits where a large portion is likely to be withdrawn during the period
  • Core Deposits and Stable Funds: Deposits unlikely to have much, if any, withdrawn; represent the most stable funding base
• Liability Liquidity Reserve: Determined by the percentage of reserves the institution maintains for each category based on withdrawal risk
• Loan-Side Considerations: Institutions must be positioned to deliver on all good loans (customers meeting loan standards with legitimate credit needs); management should incorporate potential future loans since loans often generate additional business relationships
• Strategic Balance: The method ensures adequate liquidity reserves while maintaining capacity to meet legitimate customer credit demands and build long-term banking relationships

Topic 3. Structure of Funds Approach

• Example 1: Jartens Bank has the following deposit and non-deposit liabilities broken down into three categories:
  • Hot money: 13 million; Vulnerable funds: $18  million; Core funds: $65 million
  • Legal reserves are 2.5% and desired reserve percentages for the earlier categories are 90%, 25%, and 10% respectively. Actual loans are $85 million with the potential to reach $100 million. Assuming the bank wishes to be able to meet all good loans, calculate the total liquidity requirement.​

• Creating scenarios and assigning probabilities to them allows the liquidity manager to create a weighted average liquidity requirement using the following equation:

• A liquidity manager forecasts the following scenarios for deposits and loans for next week. Calculate the expected liquidity requirement.

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Topic 4. Liquidity Indicator Approach

• Core Principle: Uses financial ratios to measure liquidity. Changes in these ratios are more important than their absolute levels.

• Ratios that indicates Higher Liquidity:

  • Cash position indicator (cash + interbank deposits/total assets)

  • Liquid securities indicator (U.S. government securities/total assets)

  • Core deposit ratio (core deposits/total assets). Core deposits are total deposits less those over $100,000.

  • Hot money ratio (money markets assets/volatile liabilities)

  • Net federal funds and repurchase agreements position: (federal funds sold and reverse repo agreements − federal funds purchased and repo agreements) / total assets.

• Ratios that indicates Higher Illiquidity:

  • Capacity ratio (net loans and leases/total assets)

  • Loan commitments ratio (unused loan commitments/total assets)

  • Pledged securities ratio (pledged securities/total securities holdings)

  • Deposit composition ratio (demand deposits/time deposits)

  • Deposit brokerage index (brokered deposits/total deposits)

Practice Questions: Q1

Q1. Which of the following indicators would create concern for a liquidity manager looking to stabilize liquidity and create confidence in the bank’s position?
A. An increasing hot money ratio.
B. An increasing deposit composition ratio.
C. Increases in reverse repurchase agreements.
D. An excess of federal funds sold over federal funds purchased.

Practice Questions: Q1 Answer

Explanation: B is correct.

The deposit composition ratio compares demand deposits to time deposits. An increasing ratio means that more deposits are demand (relative to time). Demand deposits are more volatile, as they fluctuate based on customer activity. Time
deposits are more stable in that they have set maturities and penalties for early withdrawal. Higher demand deposits create a greater liquidity concern. An increasing hot money ratio, increases in reverse repo agreements, and an excess of federal funds sold over federal funds purchased will all improve liquidity positions.

Topic 5. Market Signals/Discipline Approach

• Core Principle: A bank's liquidity position is judged by external market signals.

• Useful Market Signals:

  • Public confidence in the institution.

  • Institution's stock price performance.

  • Frequency and losses on asset sales.

  • Risk premiums on CDs and borrowings (interest rates paid).

  • Frequency and size of borrowings from the central bank.

  • Ability to meet loan requests from credit customers.

Module 3. Legal Reserves

Topic 1. Money Position Management

Topic 2. Clearing Balances, Sweep Accounts, and Fed Funds

Topic 3. Different Sources of Reserves

Topic 1. Money Position Management

• Money Position Manager Role: Tasked with managing the institution's liquidity position and ensuring sufficient legal reserves are maintained at all times
• Legal Reserves Definition: Assets required by law and central banking regulations to be held for a specific time period
• Applicable Institutions: Large commercial and savings banks, credit unions, savings and loan associations, and foreign bank branches and agencies operating in the United States
• Reserve Requirements in the U.S.: Legal reserves must be held as vault cash; if vault cash is insufficient, deposits must be maintained in reserves at the regional Federal Reserve Bank
• Bound vs. Nonbound Institutions: Bound institutions must deposit amounts at the regional Fed bank, while nonbound institutions have sufficient vault cash and do not need to deposit funds at the regional bank
• Excess Reserves: Occur when legal reserves (daily average holding amount) exceed the calculated required reserves; excess funds available for other uses
• Reserve Deficits: Occur when legal reserves fall short of calculated required reserve amounts; institutions typically must acquire additional legal reserves to cover deficits; small deficits may be carried over if an excess occurs in the next period

Topic 2. Clearing Balances, Sweep Accounts and Fed Funds

• Clearing Balance: A reserve banks voluntarily maintain with the Fed to cover debit items and checks; required minimum daily average over two-week period for using Fed's check-clearing facilities; deficits must be cleared while excesses cushion potential legal reserve deficits; interest earned offsets Fed service costs
• Factors Driving Reserve Balances: Controllable and non-controllable factors include daily draft/check volume, coin and currency shipments, government security activity, and federal funds borrowing/lending; sweep accounts (retail and business) are primary driver of overall legal reserve decline by moving deposits to higher-yielding accounts while preserving check-writing and withdrawal capabilities
• Reserve Management Goal: Maintain no excess reserves but avoid deficits large enough to trigger penalties (U.S. standard: within 4% of daily average prevents penalties)
• Managing Excess Reserves: Institutions sell federal funds to others, purchase securities, or issue new loans to deploy excess reserves productively
• Managing Reserve Deficits: Short-term deficits addressed by purchasing federal funds or borrowing from district Fed; longer-term deficits may require asset sales or reduced lending activity
• Federal Funds Market Characteristics: Relatively cheap but volatile funding source for covering large reserve deficits; effective interest rate changes by the minute though stays close to target fed funds rate
• Alternative Deficit Coverage Options: Selling liquid securities, drawing on balances at other institutions, using repurchase agreements, borrowing in Eurocurrency market, and selling time deposits; smaller institutions typically have reserve surpluses while larger institutions tend to have deficits

Topic 3. Different Sources of Reserves

• The factors that drive the decision as to which source to use are:

  • Need Duration: Central bank discount window or federal funds market preferred for short-term deficits; longer-term shortages covered through longer-term borrowing or asset sales
  • Need Immediacy: Urgent deficit coverage requires overnight loans from federal funds market or central bank discount window; non-immediate needs can be met through asset sales or deposit sales
  • Costs and Risks of Alternative Sources: Costs and availability change constantly, requiring liquidity managers to continuously monitor changes and select the cheapest source of reliable funds
  • Liquid Fund Market Access: Institutions must choose from sources they can access quickly, limiting options based on their market relationships and qualifications
  • Monetary Policy Outlook: Central bank monetary policy drives money supply, which directly impacts interest rates and funding source availability
  • Interest Rate Outlook: Fund sources with lowest expected interest rates are ideal; managers must forecast potential future rate changes to optimize funding decisions
  • Liquidity Source Rules and Regulations: Each liquidity source has unique rules and regulations that users must follow; availability timing is critical as some sources (e.g., Eurocurrency market, federal funds market) are only available during trading hours

Practice Questions: Q1

Q1. Which of the following statements is correct in regard to reserve sources?
A. Long-term asset sales are typically used to cover immediate needs.
B. Monetary policy and interest rate movements are relatively independent.
C. The federal funds market is available anytime a bank has an immediate cash need.
D. Deficits which must be covered relatively quickly are often funded through the central bank discount window.

Practice Questions: Q1 Answer

Explanation: D is correct.

Deficits that are of a more immediate nature are often funded through the central bank discount window. Long-term asset sales are typically used to cover long-term (nonimmediate) deficits. Monetary policy and interest rate movements are
highly related, as monetary policy impacts the money supply, which in turn impacts interest rates. The federal funds market is only available during the trading day.