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. Bank’s net liquidity position and factors that affect the supply and demand

Topic 2. Asset Liquidity Management

Topic 3. Liability (Borrowed Liquidity) Management

Topic 4. Balanced Liquidity Management

Topic 1. Bank’s net liquidity position and factors that affect the supply and demand

• Definition of Liquidity: Liquidity is a financial institution's access to funds that are low-cost, immediately spendable, and available exactly when needed.

  Net Liquidity Position (L): This is the critical balance calculated as the difference between the supply of liquidity (inflows) and the demand for liquidity (outflows).

• If L < 0 (Deficit): The bank must quickly raise additional funds.

• If L > 0 (Surplus): The excess funds should be prudently invested to cover future needs, balancing liquidity with profitability.

• Formula: Net Liquidity Position ($L$) = Supplies of Liquidity - Demands of Liquidity.

• Factors Affecting the Supply of Liquidity (Inflows)
  • The primary sources of spendable funds for a bank include:

1. New Deposits: Funds flowing in from customers.
2. Loan Repayments: Funds received from existing borrowers.
3. Asset Sales: Converting liquid securities into cash.
4. Fee Income: Revenue from non-deposit services.
5. Money Market Borrowings: Securing funds from external markets.

• Timing is a major factor: Short-term needs are immediate, while longer-term needs allow access to a wider range of funding sources.

• Factors Affecting the Demand for Liquidity (Outflows)

  • Demands for spendable funds typically stem from:

1. Deposit Withdrawals: Customers removing money from their accounts.
2. Credit Requests: New loan requests and draws on existing credit lines.
3. Borrowing Repayments: Paying off the institution's own liabilities.
4. Operating Payments: Cash dividend and income tax payments.

• Risks Driven by Mismatch:

  • Maturity Imbalances: Mismatch between short-term liabilities and long-term assets.

  • Interest Rate Risk: Impact of shifting market rates on asset values and customer behavior.

  • Availability Risk: Liquid funds not being available when required.

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 2. Asset Liquidity Management

• Strategy Overview: This approach maintains liquidity by holding a pool of highly liquid assets (secondary reserves) that can be converted into cash on demand. It is often used by smaller financial institutions.

• Characteristics of a Liquid Asset:

  • It has a ready market (quickly convertible to cash).

  • It has a relatively stable price (sale won't impact its value).

  • It is reversible (principal can be recovered with low risk).

• Examples of Liquid Assets: U.S. Treasury bills and government securities.

  • Certificates of Deposit (CDs).

  • Federal funds loans (funds loaned to other banks).

  • Repurchase agreements (liquid security purchases).

• ​Costs of Asset Conversion: While safe, this strategy incurs costs:

1. Opportunity Costs: Lost earnings on high-yield assets that are sold to create liquidity. The firm often has to sell assets with the lowest profit potential first.
2. Lower Returns: Liquid assets themselves (like T-bills) carry lower returns than loans, forcing the firm to balance safety with profitability.
3. Transaction Costs: Costs associated with finding buyers and executing sales.
4. Market Risk: Risk of being forced to sell assets in a declining market, crystallizing a loss.

Topic 3. Liability (Borrowed Liquidity) Management

• Strategy Overview: This strategy, often used by larger institutions, involves borrowing or purchasing funds in the money market only when needed to cover anticipated liquidity demands.

• Sources of Purchased Liquidity: Jumbo Negotiable Certificates of Deposit ($100,000$).

  • Repurchase agreements (liquid security sales).

  • Federal funds borrowings (funds borrowed from other banks).

  • Central bank discount window borrowings.

  • Eurocurrency issuances.​

• Key Advantages: Asset Portfolio Intact: Allows the bank to leave its profitable, long-term asset portfolio (loans) unaltered.
  • Flexible Volume: Can borrow the exact amount of funds required.
  • Adjustable Cost: Can adjust the interest rate offered to attract the necessary funds.

• Key Risks: Interest Rate Risk: Borrowing costs are subject to high interest rate volatility.

  • Availability Risk: Funds may not be available at a reasonable price, or at all, due to market perception or fluctuations in credit availability.

Topic 4. Balanced Liquidity Management

• Strategy Overview: This is the most common approach, involving a dynamic combination of both asset conversion (stored liquidity) and liability management (purchased liquidity).

  How it Works:

1. Stored Liquidity: Maintains a core portfolio of marketable securities to provide an immediate buffer.
2. Purchased Liquidity: Establishes pre-arranged lines of credit and access to borrowing markets for large or unanticipated needs.

• Benefit: This hybrid strategy provides maximum flexibility, allowing the institution to choose the most cost-effective and available source of funds at any given time to meet short-term or long-term needs.

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. Sources and Uses of Funds Approach

Topic 2. Structure of Funds Approach

Topic 3. Liquidity Indicator Approach

Topic 4. Market Signals/Discipline Approach

Topic 1. Sources and Uses of Funds Approach

• There are four primary approaches to estimating liquidity requirements:

  • Sources and Uses of Funds Approach: Forecasts changes in deposits and loans to determine a liquidity surplus or deficit.

  • Structure of Funds Approach: Categorizes funds based on the likelihood of withdrawal and sets aside a required reserve for each category.

  • Liquidity Indicator Approach: Uses financial ratios to gauge liquidity and compare it against industry averages.

  • Market Signals/Discipline Approach: Gauges liquidity based on market signals like stock price, risk premiums, and public confidence.

  • Core Principle: Liquidity rises with deposit increases and falls with loan increases.

  • Liquidity Gap: A mismatch between sources and uses of funds.

    • Positive Gap (Surplus): Sources > Uses

    • Negative Gap (Deficit): Uses > Sources

• Methodology:

  • Forecast deposits and loans for a specific period.

  • Estimate the changes in these amounts.

  • Calculate the net liquid funds' deficit or surplus.

• Alternative Forecasting Method: Separate growth into trend, seasonal, and cyclical components.

• Formula:​

​

Topic 2. Structure of Funds Approach

• Core Principle: Funds are categorized by their stability and likelihood of withdrawal.

• Categories of Funds:

  • Volatile (Hot Money) Liabilities: High interest rate sensitivity, high withdrawal likelihood.

  • Vulnerable Funds: Large portion is likely to be withdrawn.

  • Core Deposits (Stable Funds): Unlikely to be withdrawn.

• Calculation: A predetermined reserve percentage is applied to each category to determine the total liquidity requirement.

• Total Liquidity Requirement Formula:

• Scenario Analysis: Can be refined by creating "best case," "worst case," and "most likely" scenarios with probabilities to determine an expected liquidity requirement.

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 3. Liquidity Indicator Approach

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

• Indicators of 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)

  • Hot money ratio (short-term assets / volatile liabilities)

  • Net federal funds and repurchase agreements position

• Indicators of 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)

Topic 4. 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. Choosing Among Different Sources of Reserves

Topic 1. Money Position Management

• Role: The money position manager is responsible for ensuring the financial institution maintains a sufficient level of legal reserves.

• Legal Reserves: Assets required by law and central banking regulations. In the U.S., this includes vault cash and deposits held at the Federal Reserve.

• Key Concepts:

  • Excess Reserves: When legal reserves exceed required reserves.

  • Reserve Deficit: When legal reserves fall short of required reserves.

  • Goal: To have just enough reserves to meet requirements without incurring penalties or having excess funds that could be invested elsewhere for a higher return.

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

• Clearing Balances:

  • Reserves a bank keeps with the Fed to clear checks and cover debit items.

  • Required for banks using the Fed's check-clearing facilities.

• Sweep Accounts:

  • Move customer deposits from low-yield accounts to higher-yield accounts (e.g., money market mutual funds).

  • A primary driver for the overall decline in legal reserves.

• Federal Funds Market:

  • A primary, albeit volatile, source of funds for banks to cover large reserve deficits.

  • The effective interest rate can change by the minute.

  • Deficits can also be managed by selling liquid securities or borrowing from the district Fed.

Topic 3. Choosing Among Different Sources of Reserves

• Factors Influencing Choice:

  • Cost: The interest rate or opportunity cost associated with each source.

  • Availability: How quickly and reliably a source of funds can be accessed.

  • Volatility: The stability of the interest rate of the funding source.

  • Maturity: The length of time for which the funds are available.

• Common Sources:

  • Federal Funds: Typically a short-term, volatile, but cheap source.

  • Selling Liquid Securities: May incur a loss if the market is declining.

  • Borrowing from the Discount Window: Often seen as a signal of distress, and can have higher rates.

  • Repurchase Agreements: Short-term, collateralized borrowings.

  • Eurocurrency Market: Can be a source of funds for larger, international institutions.

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.