Liquidity and Reserves Management: Strategies and Policies

Liquidity and Reserves Management: Strategies and Policies

After completing this reading, you should be able to:

  • Calculate a bank’s net liquidity position and explain factors that affect the supply and demand for liquidity at a bank.
  • Compare the strategies that a bank can use to meet demands for additional liquidity.
  • Estimate a bank’s liquidity needs through three methods (sources and uses of funds, the structure of funds, and liquidity indicators).
  • Summarize the process taken by a US bank to calculate its legal reserves.
  • Differentiate between factors that affect the choice among alternative sources of reserves.

Bank’s Net Liquidity Position and Factors Affecting the Supply and Demand of Liquidity at a Bank

Financial institutions depend upon public confidence to survive and prosper. Additionally, liquidity can quickly get distorted when the public loses its faith with one or more institutions.

The Demand for and Supply of Liquidity

Here, we discuss various activities that give rise to the demand for liquidity and the sources that can be relied upon to supply liquidity.

For most financial firms, demand for liquidity come from a few primary sources:

  • Customers withdrawing money from their accounts.
  • Credit requests from customers the financial firm wishes to keep, either in the form of new loan requests or drawings upon existing credit lines.
  • Paying off previous borrowings.
  • Periodic payment of income taxes or cash dividends to stockholders.

Financial firms cover the demand for liquidity by drawing upon potential sources of supply:

  • Receipt of new customer deposits customers repaying their loans and from sales of assets, especially marketable securities, from the investment portfolio.
  • Revenues (fee income) generated by selling non-deposit services.
  • Borrowing in the money market.

The combined sources of demand and supply determine a financial firm’s net liquidity position at any given time.

A financial firm’s net liquidity position = Supplies of liquidity flowing into the financial firm – Demands on the financial firm for liquidity

The following formula gives a financial firm’s net liquidity position:

Net liquidity position = Incoming deposits (inflows) + Revenue from the sale of deposit services + Customer loan repayments + Sales of assets + Borrowing from the money market – Deposit withdrawals (outflow) – Volume of acceptable loan requests – Repayments of borrowings – Other operating expenses – Dividend payments to stockholders.

A liquidity deficit occurs when the demand for liquidity exceeds its supply. I.e., \({\text L}_{\text t} < 0\). On the other hand, liquidity surplus occurs when the supply for liquidity exceeds the demand for liquidity, i.e., \({\text L}_{\text t} > 0\). When there is a liquidity deficit, the management must decide when and where to raise additional funds. Also, when there is a liquidity surplus, the management decides when and where to invest surplus liquid funds until they are required to meet future cash needs and earn a profit.

Example: Calculating the Net Liquidity Position for a Bank

Suppose that a bank has the following cash inflows and outflows during the coming week:

$$ \begin{array}{l|c} \textbf{Cash Inflows} & \textbf{Amount in Million Dollars} \\ \hline \text{Customer loan repayment} & {123} \\ \hline \text{Sales of bank assets} & {32} \\ \hline \text{New deposits} & {683} \\ \hline \text{Money-market borrowings} & {55} \\ \hline \text{Non-deposit service fees} & {38} \\ \hline \textbf{Total cash inflows} & \bf{931} \\ \end{array} $$

$$ \begin{array}{l|c} \textbf{Cash Outflows} & \textbf{Amount in Million Dollars} \\ \hline \text{Deposit Withdrawals} & {$61} \\ \hline \text{Operating Expenses} & {$68} \\ \hline \text{New Loan Requests} & {$307} \\ \hline \text{Repayment of Previous Borrowings} & {$32} \\ \hline \text{Dividend to Stockholders} & {$145} \\ \hline \textbf{Total Cash Outflows} & \bf{$606} \\ \end{array} $$

The bank’s projected net liquidity position for the coming week is calculated as:

$$ \begin{align*} \text{Net Liquidity Position Projected} & = \text{Total cash inflows} – \text{Total cash outflows} \\ & = $931-$606 = $325 \text{ million} \\ \end{align*} $$

The management of liquidity is subject to the risk that interest rates changes (interest rate risk) and that liquid funds are unavailable in the volume needed (availability risk).

A rise in the market interest rate causes a decline in the value of the assets that the financial institution intends to sell to raise liquid funds. Thus, these assets are sold at a loss. The losses incurred reduce earnings and lead to fewer liquid funds raised from the sale of the assets. Furthermore, raising liquid funds by borrowing costs more. This is because as interest rates increase, some forms of borrowed liquidity may no longer be available. If lenders perceive a financial firm to be riskier than before, it is forced to pay higher interest rates to borrow liquidity.

Strategies for Liquidity Managers

Strategies that experienced liquidity managers have developed for dealing with liquidity problems include:

  1. Providing liquidity from assets (asset liquidity management).
  2. Depending on borrowed liquidity to meet cash demands (liability management).
  3. Balanced (asset and liability) liquidity management.

i. Asset Liquidity Management (or Asset Conversion) Strategies

The asset conversion strategy entails storing liquidity in assets, mainly in cash and marketable securities, so that when liquidity is needed, selected assets can be easily converted into cash to meet all demands.

Characteristics of a liquid asset include:

  • It has a ready market, making it easily convertible into cash.
  • It has a reasonably stable price, implying that the market is deep enough to absorb the sale without a substantial price decline regardless of the speed at which the asset is sold or the size of the sale.
  • It is reversible. The seller can recover his/her original principal with little risk of loss.

Since every institution’s liquidity is influenced by demands for liquidity made against it, holding more liquid assets does not necessarily make it a liquid institution. The most popular liquid assets include Treasury bills, federal fund loans, certificates of deposit, municipal bonds, federal agency securities, and euro currency loans.

This method has the advantage that smaller financial firms find it less risky for liquidity management relative to borrowing. However, it is a costly approach. There is an opportunity cost of storing liquidity in assets when they must be sold. Moreover, transaction costs or commissions paid to security brokers are involved. Furthermore, the assets in question may need to be sold in a market experiencing declining prices and increasing risk. Finally, liquid assets generally carry the lowest rates of return of all assets. Investing in liquid assets means forgoing higher returns on other assets that might be acquired.

ii. Borrowed Liquidity (Liability) Management Strategies

A liability management (purchased liquidity) strategy is an approach extensively used by the largest firms, i.e., which often borrow close to 100% of their liquidity needs. It entails borrowing immediately spendable funds to cover all anticipated demands for liquidity. The number one advantage of this approach is that it calls for borrowing funds only when the firm needs to contrast to storing liquidity in assets where a storehouse of liquid assets should be held at all times, lowering potential returns. It also allows the firm to leave the volume and asset composition of its portfolio the same if it is satisfied with the assets it currently holds. However, liquidity management comes with an interest rate offered to the borrowed funds. If the borrowing firm needs additional funds, it merely raises the offer rate until it generates the required amount of funds. The firm may lower its offer rate if it requires few funds.

The primary sources of borrowed liquidity for a depository institution include jumbo ($100,000+) negotiable CDs, federal funds borrowings, repurchase agreements, Euro currency borrowings, advances from the Federal Home Loan Banks, and borrowings at the discount window of the country’s central bank.

This strategy offers the highest expected returns with more significant uncertainty.

iii. Balanced Liquidity Management Strategies

The balanced liquidity management strategy entails combining both asset and liability management. It entails storing a portion of the expected demands for liquidity in assets while backstopping other anticipated liquidity needs by advance arrangements for lines of credit from potential suppliers of funds. Near-term borrowings are used to meet unexpected cash needs, while short-term and medium-term assets are used to meet longer-term liquidity needs. It must, therefore, raise funds from the cheapest and most timely sources available.

Estimating Liquidity Needs

Four approaches are employed to estimate a financial firm’s liquidity requirements. These include (1) the sources and uses of funds approach, (2) the structure of funds approach, (3) the liquidity indicator approach, and (4) the market signals (or discipline) approach.

1. The Sources and Uses of Funds Approach

This approach rests on two simple facts:

  • For a depository institution, liquidity rises as deposits increase, and loans decrease.
  • Liquidity decreases when deposits decrease, and loans increase.

liquidity gap arises when the sources and uses of liquidity do not match. A positive liquidity gap (surplus) arises when the sources of liquidity exceed the uses of liquidity. On the other hand, a negative liquidity gap (deficit) emerges when the uses exceed sources.

The crucial steps for the sources and uses of funds approach for a bank are as follows:

  1. Forecasting loans and deposits for a given planning period.
  2. Calculating the estimated change in loans and deposits for the same period.
  3. Estimating the net liquid funds’ surplus or deficit for the planning period by comparing the estimated change in loans (or other uses of funds) to the estimated change in deposits (or other funds sources).

The bank’s liquidity manager might prepare the following forecasting model:

The estimated change in the total loans for the coming period is a function of:

  • Projected growth in the economy.
  • Projected quarterly corporate earnings.
  • The current rate of growth in the money supply.
  • Projected prime loan rate or CD rate.
  • The estimated rate of inflation.

The estimated change in total deposits for the coming period is a function of:

  • Projected growth in personal income in the economy.
  • The estimated increase in retail sales.
  • The current growth rate of the money supply.
  • The projected yield on the money market deposits.
  • The estimated rate of inflation.

The bank can then estimate its needs for liquidity by calculating:

$$ \begin{align*} & \text{Estimated liquidity deficit (-) or surplus (+) for the coming period}\\ =& \text{Estimated change in deposits } -\text{Estimated change in loans} \\ \end{align*} $$

Future deposits (other fund sources) and loans (other fund uses) can also be calculated by dividing the forecast of future deposit and loan growth into three components:

  • A trend component: Estimated by constructing a trend (constant-growth) line using reference points year-end, quarterly, or monthly deposit and loan totals established over a base period sufficiently long to define a trend growth rate (at least 10 years).
  • A seasonal component: Measuring how other funds sources and other funds use is expected to look like in each week or month due to seasonal factors, relative to the most recent year-end deposit or loan level. The seasonal component compares the average level of deposits and loans for each week over the past 10 years to the average level of deposits and loans for the final week of December over the preceding 10 years.
  • A cyclical component: Reflects the difference between expected deposit and loan levels each week during the preceding year (measured by the trend and seasonal elements) and the actual volume of total deposits and total loans the bank posted that week.

Example: The Sources and Uses of Funds Approach

A bank estimates its total deposits and loans for the next 6 months in millions of dollars to be as given in the following table. Using the sources and uses of funds approach, we can establish when this bank faces a liquidity deficit or surplus.

$$ \begin{array}{l|c|c} \textbf{Month} & \textbf{Estimated Total Deposits} & \textbf{Estimated Total Loans} \\ \hline \text{January} & {$120} & {$100} \\ \hline \text{February} & {136} & {$105} \\ \hline \text{March} & {128} & {$114} \\ \hline \text{April} & \text{156} & {$129} \\ \hline \text{May} & {161} & {$116} \\ \hline \text{June} & {145} & {$138} \\ \end{array} $$

We focus on the liquidity deficit (-) and surplus (+) as follows:

$$ \begin{array}{l|c|c} \textbf{Month} & \bf{\text{Estimated Deposit} \\ \text{Change}} & \bf{ \text{Estimated Loan} \\ \text{Change}} & \bf{\text{Estimated Liquidity} \\ {\text{Deficit} (-) \text { or } } \\ \bf{\text{Surplus} (+)}} \\ \hline \text{January} & {$0} & {$0} & {$0} \\ \hline \text{February} & {$16} & {$5} & {$11} \\ \hline \text{March} & {($8)} & {$9} & {($17)} \\ \hline \text{April} & {$28} & {$15} & {$13} \\ \hline \text{May} & {$5} & {($13)} & {$18} \\ \hline \text{June} & {($16)} & {$22} & {($38)} \\ \end{array} $$

Evidently, the bank has projected liquidity surpluses in three out of six months. These surpluses should be invested profitably. There is also a liquidity deficit estimated for the third and sixth months. The deficit must be covered by borrowing or selling liquid assets.

2. The Structure of Funds Approach

Suppose that we have a bank that frequently faces substantial liquidity demands. Under this approach, we first divide the deposits and other fund sources into categories based on their estimated probability of being withdrawn, therefore lost to the financial firm. The resulting categories might include:

  • Hot money liabilities (volatile liabilities): These include deposits and other borrowed funds (such as federal funds borrowings) that are very interest-sensitive or that management is sure to be withdrawn during the current period.
  • Vulnerable funds: These consist of customer deposits, of which a significant portion, perhaps 25% to 30%, is probably withdrawn sometime during the current period.
  • Stable funds (core deposits or core liabilities): These consist of funds that management considers unlikely to be removed.

In the second step, the liquidity manager sets aside liquid funds according to some desired operating rules for each of the above funding categories. For example, the manager may choose to set up a 90% liquid reserve for hot money funds (less the required legal reserves held behind the hot money deposit).

For vulnerable deposit and non-deposit liabilities, a common rule of thumb is to hold a fixed percentage of their total amount—say, 30%—in liquid reserves. For stable (core) funds sources, a liquidity manager may decide to place a small proportion—say at most 15%—of their total in liquid reserves. Thus, the liquidity reserve behind deposit and non-deposit liabilities would be:

$$ \begin{align*} \text{Liability Liquidity Reserve}= & 0.95× \text{(Hot money deposits and non-deposit funds}\\& -\text{Legal reserves held)} \\ & +0.30×\text{(Vulnerable deposit and non-deposit funds}\\&-\text{Legal reserves held)} \\ & +0.15×\text{(Stable deposits and non-deposit funds}\\& – \text {Legal reserves held)} \\ & + 1.00 × \text{(Potential loans outstanding}\\& – \text{Actual loans outstanding)} \end{align*} $$

Example: The Structure of Funds Approach

Suppose that a bank’s liquidity division estimates that it holds $30 billion in hot money deposits and other IOUs against which it holds 80% liquidity reserve, $65 million in vulnerable funds against which it plans to hold a 15% reserve, and $123 million in stable funds against which it holds a 5% liquidity reserve. The bank expects its loans to grow by 10% annually. Its loans are currently standing at $129 million, but have recently reached $144 million. Assuming that the reserve requirements on liabilities currently stand at 2.5%, what is the bank’s total liquidity requirement?

$$ \begin{align*} \text{Total Liquidity Requirement}= & 0.80×(30-0.025×30) \\ & +0.15×(65-0.025×65) \\ & +0.05×(123-0.025×123) \\ & +(144+0.10×144-129) \\ & =$68.3025 \text{ million (held in} \\ & \text{liquid assets and additional borrowing capacity)} \\ \end{align*} $$

3. Liquidity Indicator Approach

Many financial institutions use liquidity indicators to estimate their liquidity needs based on experience and industry averages. The ratios are employed to estimate liquidity needs and to monitor changes in the liquidity position. The following liquidity indicators are often used for depository institutions:

$$ \text{Cash position indicator} =\cfrac {\text{Cash and cash deposits due from depository institutions}}{\text{Total assets}} $$

A higher proportion of cash implies that the institution is in a stronger position to handle immediate cash needs.

The liquidity securities indicator compares the most marketable securities an institution can hold with the overall size of its asset portfolio.

$$ \text{Liquidity Securities Indicator} =\cfrac {\text{Government securities}}{\text{Total assets} } $$

The higher the proportion of government securities, the more liquid the depository institution’s position tends to be.

Net federal funds and repurchase agreements position measures the comparative importance of overnight loans relative to overnight borrowings of reserves.

$$ \text{Net federal funds and repurchase agreements position}=\frac{({F_s} – {F_p)}}{\text{Total assets}}$$


\(F_{s}\)=Federal funds sold and reverse repurchase agreements.

\(F_{p}\)=Federal funds purchased and repurchase agreements.

A rise in this ratio increases liquidity.

Capacity ratio is a negative liquidity indicator because loans and leases are the most illiquid of the assets.

$$ \text{Capacity Ratio}=\cfrac {\text{Net loans and leases}}{\text{Total assets}} $$

Pledged securities ratio is also a negative liquidity indicator. This is because the higher the proportion of securities pledged to back U.S. government deposits, the less the securities available to sell when liquidity needs arise.

$$ \text{Pledged securities ratio}=\cfrac {\text{Pledged securities}}{\text{Total security holdings}} $$

Hot money ratio shows whether the institution has balanced the volatile liabilities it has issued with the money market instruments that it holds that could be sold quickly to cover the liabilities.

$$ \text{Hot money ratio}=\cfrac {\text{Money market (short-term) assets}}{\text{Volatile liabilities}} $$

or could be rewritten as:

$$ \begin{align*} = & (\text{Cash and due from deposits held at other depository institutions} \\ & +\text{Holdings of short-term securities} \\ & \cfrac {+\text{Federal funds loans} +\text{Reverse repurchase agreements)}}{(\text{Large CDs+Eurocurrency deposits}} \\ & +\text{Federalfunds borrowings+repurchase agreements)} \\ \end{align*} $$


$$ \text{Deposit brokerage index}=\cfrac {\text{Brokered deposits}}{\text{Total deposits}} $$

Where brokered deposits consist of packages of funds (usually at most $100,000 to obtain the advantage of deposit insurance) arranged by securities brokers for their customers with firms paying the highest yields, brokered deposits are interest-sensitive and may be withdrawn quickly. The more a depository institution holds, the higher the chance of a liquidity crisis.

$$ \text{Core deposit ratio}=\cfrac {\text{Core deposits}}{\text{Total assets}} $$

Where core deposits are typically small-denomination checking and savings accounts that are treated as unlikely to be withdrawn on short notice, thus having lower liquidity requirements.

Deposit composition ratio measures how stable a funding base each institution possesses. A decline suggests more excellent deposit stability and a lesser need for liquidity.

$$ \text{Deposit composition ratio}=\cfrac {\text{Demand deposits}}{\text{Time deposits}} $$

Where demand deposits are prone to immediate withdrawal via check writing, on the other hand, time deposits carry fixed maturities with penalties for early withdrawal.

Loan commitment ratio measures the volume of promises a lender has made to its borrowers to provide credit up to a prespecified amount for a specified period.

$$ \text{Loan commitments ratio}=\cfrac {\text{Unused loan commitments}}{\text{Total assets }} $$

Example Liquidity Indicator Approach

ABC Bank Ltd.’s excerpt of balance sheet entries as of today’s date is given in the following table:

$$ \begin{array}{l|c} \textbf{Item} & \textbf{Amount in Million Dollars} \\ \hline \textbf{Assets} & {} \\ \hline \text{Net loans and leases} & {3,681} \\ \hline {\text{Cash and deposits held at} } & {807} \\ {\text{other depository institutions}} & {} \\ \hline \text{Federal funds sold} & {217} \\ \hline \text{Government securities} & {349} \\ \hline \text{Total assets} & {4,605} \\ \hline \textbf{Liabilities} & {154} \\ \hline \text{Federal funds purchased} & {211} \\ \hline \text{Demand deposits} & {1,132} \\ \hline \text{Time deposits} & {2,766} \\ \end{array} $$

Using these entries, we can compute various liquidity indicators for ABC Bank Ltd, as shown in the following table:

$$ \begin{array}{l|c} \textbf{Liquidity Indicator} & \textbf{Value} \\ \hline \text{Cash position indicator} & {17.52\%} \\ \hline \text{Liquidity securities indicator} & {7.58\%} \\ \hline \text{Net Federal funds position} & {0.13\%} \\ \hline \text{Capacity ratio} & {79.93\%} \\ \hline \text{Deposit composition ratio} & {40.93\%} \\ \end{array} $$

4. The Standard for Assessing Liquidity Needs: Signals from the Marketplace

No financial institution can confidently tell if it has sufficient liquidity until it has passed the market’s test. Notably, the management should look at the following signals:

Public confidence: The firm’s customers may lose confidence in it if they believe there is expected danger making the firm unable to meet its obligations.

Stock price behavior: If the investors perceive that the institution is experiencing a liquidity crisis, the firm’s stock prices decline.

Risk premiums on CDs and other borrowings: The market imposes a risk premium in the form of higher borrowing costs if it believes the institution is headed for a liquidity crisis.

Loss sales of assets: This arises when the firm is pushed to sell its assets in a hurry, with significant losses, to meet demands for liquidity.

Meeting commitments to credit customers: Here, we focus on the firm’s ability to meet all possible profitable requests for loans from its esteemed customers. Further, we establish if liquidity pressures may have compelled management to turn down some otherwise acceptable credit applications.

Borrowings from the central bank: We consider if the firm has been forced to borrow in larger volumes and more frequently from the central bank in its home territory (such as the Federal Reserve or Bank of Japan). Additionally, we examine if the central bank officials have begun to question the institution’s borrowings.

Legal Reserves and Money Position Management

The Money Position Manager

The money position manager makes quick decisions that have potential long-run consequences on profitability. Smaller banks and thrifts often hand this job over to more significant depositories with whom they have a correspondent relationship (that is, that hold deposits to help clear checks and meet other liquidity needs).

Legal Reserves

The money position manager ensures that his/her financial firm maintains an adequate level of legal reserves. These are the assets that the law and the central bank regulation set to be held during a period. The legal requirements also make sure that an institution holds not more than the minimum legal requirements since excess legal reserves yield no income for the bank.

These requirements apply to all qualified depository institutions. These include commercial and savings banks, credit unions, savings and loan associations, and agencies and branches of foreign banks offering transaction deposits or business time deposits or borrowing through Eurocurrency liabilities.

Calculating Legal Reserve Requirements

The lagged reserve accounting (LRA) current system of accounting is the accounting standard for legal reserves. To derive the bank’s total legal reserve requirements, each reservable liability item is multiplied by the expected reserve requirement percentage set by the Federal Reserve Board.

$$ \begin{align*} & \text{Total required legal reserves} \\ & =\text{Reserve requirement on transaction deposits} \\ & × \text{Daily average amount of net transaction deposits over a designated period} \\ & +\text{Reserve requirement on nontransactional reservable liabilities} \\ & × \text{Daily average amount of nontransaction reservable liabilities} \\ \end{align*} $$

Non-transaction liabilities currently have a reserve requirement of zero.

Example: Calculating Legal Reserve Requirements

The legal reserve requirements in the United States are as follows:

The first $10.7 million of net transaction deposits are subject to a 0% legal reserve requirement (known as the “exemption amount”). The volume of net transaction deposits over $10.7 million up to $58.8 million carries a 3% reserve requirement (known as the “low reserve tranche”), while the amount over $58.8 million is subject to a 10% reserve requirement (the “high reserve tranche”). Non-transaction reservable liabilities (including nonpersonal time deposits and Eurocurrency liabilities) are subject to a 0% reserve requirement.

Assume that ABC Bank Ltd.’s net transaction deposits averaged $152 million over the latest reserve computation period. Its non-transaction reservable liabilities had a daily average of $210 million over the same period.

ABC Bank Ltd.’s daily average requires a legal reserve level computed as follows:

$$ \begin{align*}  \text{Required}\\ \text{legal reserves}& = 0.0×10.7 \\ & + 0.03×[\text{ First } 58.8\\ & – 10.7 \text{ of transaction deposits}]  \\ & + 0.10 (152- 58.8)[\text{Amount of transaction deposits in excess of } $58.8 \text{M}] \\ & =$10.763 \text{M} \\ \end{align*} $$

Assume that ABC Ltd. held a daily average of $9 million in vault cash over the required latest reserve computation period. Therefore, it must hold an additional amount of legal reserves over its latest reserve maintenance period as follows:

Daily average level of additional legal reserves. ABC Bank Ltd. Must raise:

$$ \begin{align*} & =\text{Total required legal reserves-Daily average vault cash holdings} \\ & = $ 10.763\text{ million} – $9.000 \text{ million} = $1.763 \text{ million} \\ \end{align*} $$

Management must plan on how to invest the excess reserve taking into consideration any expected drain on funds shortly and considering any reserve deficit in the previous period.

Factors Influencing the Money Position

A depository institution’s money position can be influenced by various factors, with some of these factors mostly controllable by management, while others are fundamentally non-controllable. The management needs to anticipate and react to them quickly. These factors are shown in the following table:

$$ \begin{array}{l|c} \bf{\text{Controllable Factors Increasing} } & \bf{\text{Controllable Factors Decreasing} } \\ \textbf{Legal Reserves} & \textbf{Legal Reserves} \\ \hline \text{Selling securities} & \text{Purchasing securities} \\ \hline \text{Receiving interest} & \text{Making interest payments} \\ \text{payments on securities} & \text{to investors holding} \\ {} & \text{the bank’s securities} \\ \hline \text{Borrowing reserves from} & \text{Repaying loans from the} \\ \text {the Federal Reserve bank} & \text{Federal Reserve bank.} \\ \hline \text{Purchasing federal funds} & \text{Selling federal funds} \\ \text{from other banks} & \text{to other institutions} \\ {} & \text{that need reserves} \\ \hline \text{Selling securities under} & \text{Security purchases under a} \\ \text{a repurchase agreement (RP)} & \text{repurchase agreement (RP)} \\ \hline \text{Selling new CDs,} & \text{Receiving currency and} \\ \text{Euro currency deposits, or} & \text{coin shipments from } \\ \text{other deposits to customers} & \text{the Federal Reserve bank} \\ \end{array} $$


$$ \begin{array}{l|c} \textbf{Noncontrollable Factors } & \textbf{Noncontrollable Factors} \\ \textbf{Increasing Legal Reserves} & \textbf{Decreasing Legal Reserves} \\ \hline \text{Surplus position at the local} & \text{Deficit position at the local} \\ \text{clearinghouse. This is due to receiving} & \text{clearinghouse. This is as a result of} \\ \text{more deposited checks in its favor} & \text{more checks drawn against the} \\ \text{than checks drawn against it} & \text{bank than in its favor} \\ \hline \text{Credit from cash letters sent to the} & \text{Calls of funds from the bank’s} \\ \text{Federal reserve bank, listing drafts} & \text{tax and loan account by } \\ \text{received by the bank} & \text{the U.S. Treasury} \\ \hline \text{Deposits made by the government} & \text{Debits received from the Federal} \\ \text{treasury into a tax and loan} & \text{Reserve bank for checks drawn} \\ \text{account held at the bank} & \text{against the bank’s reserve account.} \\ \hline \text{Credit received from the Federal} & \text{Withdrawal of large deposit accounts,} \\ \text{Reserve bank for checks previously} & \text{often immediately by wire} \\ \text{sent for collection} & \text{} \\ \text{} & \text{} \\ \end{array} $$

Clearing Balances

Besides holding a legal reserve account at the central bank, many depository institutions also have a clearing balance with fed to cover any checks or other debit items drawn against them. The amount is decided by its estimated check clearing needs and the record of overdrafts. The clearing balance can be beneficial since the firm earns credits from holding this balance with the Federal reserve bank, and this credit can be used to settle the fees the Fed charges for services.

For example, suppose a bank has a clearing balance averaging $1.5 million during a most recent maintenance period, and the federal funds’ interest rate over this same period averaged 6%. Then it would earn a Federal Reserve credit of:

$$ \begin{align*} \text{Reserve credit} & = \text{Average clearing balance}×\text{Annualized federal funds rate} × \left(\cfrac {14\text{ days}}{360\text{ days}} \right) \\  & = $1,500,000×0.06×\cfrac {14}{360} = $3,500\end{align*} $$

Sweep Accounts

A sweep account is a contractual agreement between a bank and a customer that permits the bank to move funds out of a customer checking account (such as a savings account with zero reserve requirement) overnight to generate higher returns for the customer and lower reserve requirements for the bank.

Sweep accounts help in lowering the overall cost of the bank’s funds while allowing the customer to access their deposits for payments. These services account for nearly $200 billion in current deposit balances and therefore have significantly reduced the total reserve requirements of banks.

Factors in Choosing the Different Sources of Reserves

Several factors must consider by the money position manager when deciding on the sources of reserves to choose from. These include the immediacy of need, duration of need, access to the market for liquid funds, current and expected interest rates, and outlook for central bank monetary policy. Additionally, relative costs and risks of alternative sources of funds, as well as the rules and regulations applicable to a liquidity source, are crucial when choosing different sources of reserves.


Allied Trust Bank (ATB) has experienced robust growth in the past decade. Despite its success, the bank is navigating an increasingly competitive financial environment and rising regulatory demands. Recently, ATB has faced an unprecedented surge in loan demand due to favorable market conditions. Amid this demand, ATB’s Chief Financial Officer (CFO) has noticed a declining liquidity ratio. In a board meeting, the CFO presents three distinct strategies to tackle potential liquidity shortages.

  1. Relying primarily on ATB’s reserve of marketable securities, Treasury bills, and CDs to generate cash.
  2. Initiating substantial borrowings from sources like jumbo negotiable CDs, repurchase agreements, and central bank discount window borrowings.
  3. Implementing a mix of the above two strategies, wherein liquid assets are judiciously used and backed by prearranged lines of credit from reliable lenders.

Considering the current market scenario and the potential risks and benefits associated with each approach, which strategy would be the most prudent for ATB?

A. Strictly follow the asset liquidity management approach by liquidating assets like marketable securities and Treasury bills.

B. Embrace the liability management approach, focusing on significant borrowings from diverse sources.

C. Combine both asset and liability management approaches to create a balanced liquidity management strategy.

D. Secure additional capital from investors while maintaining the current asset-liability structure.


The correct answer is C.

A balanced liquidity management strategy offers a versatile approach to address liquidity demands. By using a combination of liquidating readily available assets and borrowing, ATB can meet liquidity requirements without overly compromising its asset portfolio or assuming excessive borrowing risk. Furthermore, it grants the bank flexibility in dealing with liquidity needs, making it the most prudent choice in the current circumstances.

A is incorrect. Solely depending on the asset liquidity management approach exposes ATB to the opportunity cost of lost earnings from assets which are sold to create liquidity. Moreover, constantly liquidating assets can erode the bank’s balance sheet strength over time.

B is incorrect. The liability management approach, though effective in some scenarios, is risky due to interest rate volatility, unpredictable borrowing costs, and fluctuations in credit availability. Relying solely on this method might expose ATB to undue financial risk.

D is incorrect. While securing additional capital from investors might bolster liquidity in the short term, it does not offer a sustainable approach to manage liquidity needs. Additionally, this option doesn’t adapt to changing market scenarios or provide the flexibility inherent in a balanced liquidity management strategy.

Things to Remember

  • A balanced liquidity management strategy merges the benefits of both asset and liability management approaches.
  • It allows an institution to fluidly adapt to liquidity needs by strategically liquidating assets and securing borrowings when necessary.
  • This approach offers the versatility to meet immediate liquidity demands while minimizing risks tied to excessive asset liquidation or unchecked borrowing.
  • For institutions facing unpredictable liquidity situations, this combined strategy offers the resilience and adaptability needed to navigate such challenges.
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    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.