Page 1 of 20 FIN 4324 Exam III Study Guide FIN 4324 EXAM III REVIEW Covers Chapter: 11, 12, 13, and 14 11) CHAPTER 11: LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES AND POLICIES a) Liquidity i) A financial firm is considered liquid if it has ready access to immediately spendable funds at reasonable cost at precisely the time those funds are needed b) The demand for and supply of liquidity i) What causes the demand for liquidity (1) Customers withdrawing funds from their accounts (2) Credit requests from customers the institution wishes to keep (3) Paying off previous borrowings (4) Payment of income taxes or dividends to stockholders ii) Sources to supply the demand for liquidity (1) Receipt of new customer deposits (2) Customers repaying their loans (3) Sales of assets (esp. marketable securities) (4) Revenue (fee income) (5) Borrowings in the money market iii) Net liquidity position (1) Liquidity deficit = <0 ; the firm must increase the amount of liquid funds (2) Liquidity surplus = >0 ; the firm must invest liquid funds in investments iv) Managing liquidity (1) Longer term liquidity needs arise from seasonal, cyclical and trend factors (a) Fall and summer generally brings greater demand (2) Most liquidity issues arise from outside the firm (a) A customers lack of liquidity will increase demand for the firm to supply funds to the customer (3) Demand for liquidity rarely is the same as the supply of liquidity (4) Financial firms must face the trade-off between liquidity and profitability (a) The more funds set aside to deal with liquidity issues, the fewer funds available for long-term investments c) Why financial firms often face significant liquidity problems i) Firms generally borrow short-term funds from depositors and lend out that money to long-term borrowers, leading to a maturity mismatch. ii) Most depository institutions hold a large amount of liabilities that are subject to immediate demand of payment (checkable deposits). This uncertainty about maturity necessitates firms to meet immediate increases in liquidity demand iii) Changing interest rates affect liquidity (1) Rising interest rates may lead customers to withdrawal funds (liquidity demand increases)Page 2 of 20 FIN 4324 Exam III Study Guide d) Strategies for liquidity managers i) Asset liquidity management (1) Liquidity needs can be met by asset conversion (converting liquid assets into cash) (2) Typically used by smaller institutions (3) Liquid assets must meet three requirements: (a) Must have a ready market so it may be converted to cash without delay (b) Must have a reasonably stable price so that the market can absorb the sale no matter how large (without a decline in price) (c) Must be reversible (meaning the seller can buy the asset back with little risk of loss) (4) The most liquid assets = T-Bills, fed. fund loans, CD’s, muni. bonds, etc. (5) Asset conversion can bring about costs (a) Firms that convert assets to cash will lose out on the future earning those assets may have generated (opportunity costs) (b) Many sales involve transaction costs (c) Firms may have to sell assets in a market with declining prices ii) Borrowed liquidity (liability) management strategies (1) Also called purchased liquidity, liability management is the practice of firms borrowing funds from the money market to cover all anticipated demands for liquidity (2) Typically used by the largest institutions (3) Advantages: (a) Firms can borrow only what they need, when they need. (as opposed to asset management which requires firm to constantly store liquidity in assets) (b) Allows firm to not change its asset makeup (asset management may require a firm to decrease its amount of assets) (c) Firms can control how much funding it needs by the interest rate it offers to lenders (4) Disadvantages (a) Most risky approach to liquidity management (b) Volatile interest rates can change borrowing costs (firms many times must borrow liquidity at times when interest rates are the highest) (c) Institutions that must borrow a lot of liquidity are faced with pessimistic customers that may withdrawal funds and lenders that are less likely to offer funds (because of the perception that the bank is in trouble). (5) Sources of borrowed liquidity (a) Jumbo negotiable CD’s (b) Federal funds borrowings (c) Repurchase agreements (d) Eurocurrency borrowings (e) Borrowing from discount windows at central banks iii) Balanced liquidity management strategies (1) In this strategy, banks use a mix of asset and liability management (a) Immediate cash needs are solved by near-term borrowings (liability) (b) Long-term liquidity needs are solved by converting short/medium term assets to cash as needed iv) Guidelines for liquidity managers (1) Liquidity managers must keep track of the activities of all departments using/supplying funds (2) Liquidity managers should know in advance when the biggest credit or funds supplying customers plan to withdraw their funds or add fundsPage 3 of 20 FIN 4324 Exam III Study Guide (3) Liquidity managers must make sure the financial firm’s priorities and objectives for liquidity management are clear (4) Liquidity managers must analyze liquidity needs on a continuing basis to avoid surplus and deficit situations e) Estimating liquidity needs i) The sources and uses of funds approach (1) Based on two assumptions (a) Liquidity rises as deposits increase and loans decrease (b) Liquidity decreases as deposits decrease and loans increase (2) Steps (a) Loans and deposits are forecasted for a given period (b) The estimated change in deposits and loans in calculated (c) The liquidity gap must then be estimated by comparing the changes in deposits and loans (i) Liquidity gap = the deference between the sources and uses of funds (3) Components of estimating future deposits and future loans (a) Trend Component = estimated by constructing a trend line using past loan and deposit amounts as reference points (b) Seasonal component = measuring how deposits and loans are expected to behave at any time due to seasonal factors (c) Cyclical component = represents positive or negative changes from the deposit / loan totals due to changes in the economy (4) All of the above components are combined to determine the expected deposits / loans for a given period of time (Ex. below: Deposit forecasting) Deposit forecast for: Trend estimate for