Liability and Liability and Liquidity Liquidity

ManagementManagement

Chapter 18

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

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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.

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Liquid Asset Management

Examples: T-bills, T-notes, T-bonds Benefits of holding large quantities of liquid

assets Costs of holding liquid assets Regulatory requirements for minimum

levels of liquid assets

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Liquid Asset Management

Reasons for regulating minimum holdings of liquid assets: Monetary policy

Multiplier effect of changes in reserve requirements Taxation

Due to absence of interest on reserves requiring reserves constitutes transfer of a resource to the central bank.

Note interesting responses such as sweep programs

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Composition

Composition of liquid asset portfolio Liquid assets ratio

Cash and government securities in countries such as U.K.

Similar case for U.S. life insurance companies (regulated at state level)

U.S. banks: cash-based, but banks view government securities as secondary, or buffer reserves.

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Return-Risk Trade-off

Cash immediacy versus reduced return Constrained optimization

Privately optimal reserve holdings Regulator imposed reserve holdings

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U.S. Cash Reserve Requirements

Incremental reserve requirements for transaction accounts: Less than $8.5 million 0.0% $8.5 million to $45.8 million 3.0% Over $45.8 million 10.0%

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Web Resources

For information on reserve requirements, visit

Federal Reserve www.federalreserve.gov

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Reserve Management Problem

Computation period runs from a Tuesday to a Monday, 14 days later. Average daily reserves are computed as a fraction of the average daily deposits over the period. This means that Friday deposit figures count 3 times in the average for the week.

In the past, “Weekend Game” Sweep accounts

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Reserve Management

The reserve maintenance period, begins 17 days after the end of the computation period (or 30 days after the start of the computation period) Lagged reserve accounting as of July 1998. Previously, contemporaneous (2-day lag).

Benefits of lagged reserve accounting

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Undershooting/Overshooting

Allowance for up to a 4% error in average daily reserves without penalty. Surplus reserves required for next 2-week

period Undershooting by more than 4% penalized

by a 2% markup on rate charged against shortfall.

Frequent undershooting likely to attract scrutiny by regulators

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Undershooting

DI has two options near the end of the maintenance period Liquidate assets Borrow reserves

fed funds repurchase agreements

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Discount Window

Reserve shortfalls in the past Discount window borrowing

Primary credit

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Overshooting

First 4 percent can be carried forward to next period

Excess reserves typically low due to opportunity costs Significant role of investment portfolio in

managing liquidity Impact of technology and the Check Clearing

for the 21st Century Act Knife-Edge management problem

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Funding Risk versus Cost

Funding Cost

Funding Risk

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Liability Management

Note the tradeoff between funding risk and funding cost. Demand deposits are a source of cheap funds

but there is high risk of withdrawal. NOW accounts: manager can adjust the explicit

interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.

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Deposit Accounts

Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month.

Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.

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Time Deposits and CDs

Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable.

Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable.

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Fed Funds

Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day.

Fed funds rate can be highly variable Prior to July 1998: especially around the

second Tuesday and Wednesday of each period with contemporaneous reserve accounting (as high as 30% and lows close to 0% on some Wednesdays).

Rollover risk Continental Illinois Bank, for example.

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Repurchase Agreements

RPs are collateralized fed funds transactions. Usually backed by government securities. Can be more difficult to arrange than simple fed

funds loans. Generally below fed funds rate

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Other Borrowings

Bankers acceptances Commercial paper Medium-term notes Discount window loans

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Historical Notes

Since 1960, ratio of liquid to illiquid assets has fallen from about 48% to about 15.59% in 2006. But, loans themselves have also become more liquid.

Securitization and sales of DI loans In the same period, there has been a shift away

from sources of funds that have a high risk of withdrawal.

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Historical Notes

During the period since 1960: Noticeable differences between large and small

banks with respect to use of low withdrawal risk funds.

Differences in access to purchased funds and capital markets

Reliance on borrowed funds does have its own risks as with Continental Illinois.

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Liquidity Risk in Other FIs

Insurance companies Diversify across contracts Hold marketable assets

Securities firms Example: Drexel Burnham Lambert

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Pertinent Website

Federal Reserve Bank www.federalreserve.gov

Federal Deposit Insurance Corporation www.fdic.gov