1 Supply demand of liquidity Demands for funds usually come from 2 sources i Customers withdrawing money from their accounts ii Credit requests from customers the institution wishes to keep either in the form of new loan requests or drawing upon existing credit lines iii Other demands paying off previous borrowings payment of income taxes or dividends Supply of reserves 3 i The most important source for a depository institutions normally is receipt of new customer deposits ii Customers repaying their loans and from sale of assets iii Fee income generated by selling nondeposit services from borrowing in the money market 2 Estimation of liquidity Most financial firms make sure their liquidity reserves include both a planned component consisting of the reserves called for by the latest forecast a protective component consisting of an extra margin of liquid reserves over those dictated by the most recent forecast 4 estimation methods i The Sources and Uses of Funds Approach 367 o This method for estimating liquidity begins with 2 simple facts a In the case of a bank for example liquidity rises as deposits increase and loans decrease b Alternatively liquidity declines when deposits decrease and loans increase o Whenever sources and uses of liquidity do not match there is a liquidity gap measured by the size of the difference between the sources of liquidity and the uses of liquidity o Sources uses positive liquidity gap surplus o Uses sources negative gap deficit must raise funds o The key steps in this approach are a Loans and deposits must be forecast for a given planning period b The estimated change in loans and deposits must be calculated for that same period c Liquidity manager must estimate the net liquid funds surplus or deficit for the planning period by comparing the estimated change in loans to estimated change in deposits o A simpler approach for estimating future deposits and loans is to divide the forecast of future deposit and loan growth into 3 components a A trend component estimated by constructing a trend line using as reference points year end quarterly or monthly deposits and loan totals established over at least the last 10 years b A seasonal component measuring how deposits and loans are expected to behave in any given week or month due to seasonal factors c A cyclical component representing positive or negative deviations from a banks total expected deposits and loans depending on the strength or weakness of the economy in the current year ii The Structure of Funds Approach o Requires each financial firm to classify its funds uses and sources according to their probability of withdrawal or loss o In the first step of this approach deposits and other fund sources are divided into categories based upon their estimated probability of being withdrawn and therefore lost to the financial firm example of a banks deposit and nondeposit liabilities that are divided into 3 categories below a Hot money liabilities very interest sensitive or that management is sure will be withdrawn during the current period b Vulnerable funds customer deposits of which a substantial portion will probably be withdrawn sometime in the current period c Stable funds funds that management considers unlikely to be removed o Second the liquidity manager must set aside liquid funds according to some desired operating rule for each of these sources a A common rule of thumb for vulnerable deposits and nondeposit liabilities is to hold a fixed percentage of their amount say 30 in liquid reserves For stable funds manager may hold around 15 of their total in liquid reserves o The liquidity manager will want to define the best and the worst possible liquidity positions his financial institution might find itself in and assign probabilities to each See 18 calculation iii Liquidity Indicator Approach o Many financial institutions estimate their liquidity needs based upon experience and industry averages o Liquidity managers usually focus on changes in their institutions liquidity indicators rather than on the level of each indicator o Examples of indicators cash position indicator liquid securities indicator capacity ratio core deposit ratio iv Signals from the Marketplace Market Signals Approach o Many analysts believe there is one ultimately sound method for assessing a financial institutions liquidity needs and how well it is fulfilling them this method centers on the discipline of the financial marketplace o Managers should closely monitor the following market signals a Public confidence b Stock price behavior c Risk premiums on CDs and other borrowing d Loss sales of assets e Meeting commitments to credit customers f Borrowings from the central bank 3 Controllable legal reserves The manager of the money position is responsible for ensuring that his or her institution maintains an adequate level of legal reserves that is those assets that law and central bank regulation say must be held during a particular time period Controllable factors increasing legal reserves i Selling securities ii Receiving interest payment on securities iii Borrowing reserves from the Fed iv Purchasing Fed funds from other banks v Selling securities under a repurchase agreements vi Selling new CDs Eurocurrency deposits or other deposits to Controllable factors decreasing legal reserves i Purchasing securities ii Making interest payments to investors holding the bank s customers securities iii Repaying a loan from the Fed iv Selling Fed funds to other institutions in need of reserves v Security purchases under a repurchase agreements vi Receiving currency and coin shipments from the Fed 4 Criteria for bank capitalization Well capitalized faces no significant regulatory restrictions on its Adequately capitalized cannot accept broker placed deposits without expansion regulatory approval 5 Basel Agreements major criteria Undercapitalized a US depository institution that failed to meet one or more of the capital minimums for an adequately capitalized institution Subject to regulatory restrictions Significantly undercapitalized all restrictions Critically undercapitalized all restrictions and require regulatory approval for such transactions as granting loans making changes in their charter paying above market interest rate etc Set of international rules that required many of the largest banks to separate their on balance sheet and off balance sheet assets into risk categories and to multiply each asset by its appropriate risk