Introduction

• An old-fashioned “run” on the bank reminds us of at least two things:
  • How much financial institutions depend upon public confidence to survive and prosper.
  • How quickly the essential item called “liquidity” can be eroded when the public, even temporarily, loses its confidence in one or more institutions.
• A financial firm can be closed if it cannot raise sufficient liquidity even though, technically, it may still be solvent. For example, during the 1990s, the Federal Reserve forced the closure of the $10 billion Southeast Bank of Miami because it couldn’t come up with enough liquidity to repay the loans it had received from the Fed. Moreover, the competence of liquidity managers is an important barometer of management’s overall effectiveness in achieving any institution’s goals.

The Demand For And Supply Of Liquidity

• For most financial institutions, the most pressing demands for spendable funds generally come from two sources:
  • Customers withdrawing money from their accounts.
  • Credit requests from customers the institution wishes to keep, either in the form of new loan requests or drawings upon existing credit lines.
• Other sources of liquidity demand include paying off previous borrowings, such as loans the institution may have received from other financial firms or from the central bank (e.g., the Federal Reserve System). Similarly, payment of income taxes or cash dividends to stockholders periodically gives rise to a demand for immediately spendable cash.
• The most important supply source of liquidity for a depository institution normally is the receipt of new customer deposits. These deposit inflows tend to be heavy at the first of each month as business payrolls are dispensed, and they may reach a secondary peak toward the middle of each month as bills are paid. Another important element in the supply of liquidity comes from customers repaying their loans and from sales of assets, especially marketable securities, from the investment portfolio. Liquidity also flows in from revenues (fee income) generated by selling non-deposit services and from borrowings in the money market.

\(\text{Supplies of liquidity (S)} = \text{incoming deposits (inflows)} + \text{revenue from nondeposit services} + \text{customer loan repayments} + \text{sales of assets} + \text{borrowings from money market}\) (\text{Demands for liquidity (D)} = \text{deposit withdrawals (outflows)} + \text{volume of acceptable loan requests} + \text{repayments of borrowings} + \text{other operating expenses} + \text{dividend payments to stockholders}\) \(\text{net liquidity position (L)} = \text{supplies of liquidity (S)} – \text{demands for liquidity (D)}\)

• When the demand for liquidity exceeds its supply (i.e., (L < 0)), management must prepare for a liquidity deficit, deciding when and where to raise additional funds. On the other hand, if at any point in time the supply of liquidity exceeds all liquidity demands (i.e., (L > 0)), management must prepare for a liquidity surplus, deciding when and where to profitably invest surplus liquid funds until they are needed to cover future cash needs.
• Liquidity has a critical time dimension:
  • Some liquidity needs are immediate or nearly so. For example, several large CDs may be due to mature tomorrow, and the customers may have indicated they plan to withdraw these deposits rather than rolling them over into new deposits.
  • Longer-term liquidity demands arise from seasonal, cyclical, and trend factors. For example, liquid funds are generally in greater demand during the fall and summer coincident with school, holidays, and travel plans.
• Most liquidity problems arise from outside the financial firm as a result of the activities of customers. In effect, customers’ liquidity problems gravitate toward their liquidity suppliers. A dramatic example of this was the stock market crash in October 1987.

• The two main challenges of liquidity management are:
  • Demands for liquidity are rarely equal to the supply of liquidity at any particular moment in time. The financial firm must continually deal with either a liquidity deficit or a liquidity surplus.
  • There is a trade-off between liquidity and profitability. The more resources are tied up in readiness to meet demands for liquidity, the lower is that financial firm’s expected profitability (other factors held constant).

Thus, ensuring adequate liquidity is a never-ending problem for management.

• Moreover, resolving liquidity problems subjects a financial institution to costs, including:
  • Interest cost on borrowed funds.
  • The transactions cost of time and money in finding adequate liquid funds.
  • An opportunity cost in the form of future earnings that must be forgone when earning assets are sold in order to meet liquidity needs.
• The management of liquidity is subject to the risks that interest rates will change (interest rate risk) and that liquid funds will not be available in the volume needed (availability risk).

Why Financial Firms Face Significant Liquidity Problems

• Depository institutions typically face an imbalance between the maturity dates attached to their assets and the maturity dates of their liabilities. Rarely will incoming cash flows from assets exactly match the cash flowing out to cover liabilities. A problem related to the maturity mismatch situation is that most depository institutions hold an unusually high proportion of liabilities subject to immediate payment, especially demand (checkable) deposits and money market borrowings. They must stand ready to meet immediate cash demands that can be substantial at times, especially near the end of a week, near the first of each month, and during certain seasons of the year.
• Another source of liquidity problems is sensitivity to changes in market interest rates. When interest rates rise, some customers withdraw their funds in search of higher returns elsewhere. Many loan customers may postpone new loan requests or speed up their drawings on those credit lines that carry lower interest rates. Thus, changing market interest rates affect both customer demand for deposits and customer demand for loans, each of which has a potent impact on a depository institution’s liquidity position. Moreover, movements in market interest rates affect the market values of assets the financial firm may need to sell in order to raise additional funds, and they directly affect the cost of borrowing in the money market.

Strategies For Liquidity Managers

Over the years, experienced liquidity managers have developed several strategies for dealing with liquidity problems:

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

1) Asset Liquidity Management (or Asset Conversion) Strategies

The oldest approach to meeting liquidity needs is known as asset conversion. In its purest form, this strategy calls for storing liquidity in assets, predominantly in cash and marketable securities. When liquidity is needed, selected assets are converted into cash until all demands for cash are met.

A liquid asset must have three characteristics:

• i. A liquid asset has a ready market so it can be converted into cash without delay.
• ii. It has a reasonably stable price so that, no matter how quickly the asset must be sold or how large the sale is, the market is deep enough to absorb the sale without a significant decline in price.
• iii. It is reversible, meaning the seller can recover his or her original investment (principal) with little risk of loss.

Among the most popular liquid assets are:

• Treasury bills
• Federal funds loans to other institutions – These are loans of reserves held by depository institutions with short (often overnight) maturities.
• Repurchase agreements (RP)
• Correspondent deposits with various depository institutions – These interbank deposits can be borrowed or loaned in minutes by telephone or by wire.
• Municipal bonds and notes
• Federal agency securities – These are short and long-term debt instruments sold by federally sponsored agencies such as FNMA (Fannie Mae) or FHLMC (Freddie Mac).
• Negotiable certificates of deposit – These are short-term CDs which can be converted into cash without penalty.
• Eurocurrency loans – These are lending of deposits accepted by bank offices located outside a particular currency’s home country for periods stretching from a few days to a few months.

Asset conversion strategy is used mainly by smaller financial institutions that find it a less risky approach to liquidity management than relying on borrowings. But it is not a costless approach.

• First, selling assets means loss of future earnings those assets would have generated had they not been sold off. Thus, there is an opportunity cost to storing liquidity in assets when those assets must be sold.
• Most asset sales also involve transactions costs (commissions) paid to security brokers.
• Moreover, the assets in question may need to be sold in a market experiencing declining prices and increasing risk.
• Selling assets to raise liquidity also tends to weaken the appearance of the balance sheet because the assets sold are often low-risk securities that give the impression the financial firm is financially strong.
• Finally, liquid assets generally carry the lowest rates of returns. Investing in liquid assets means forgoing higher returns on other assets that might be acquired.

2) Borrowed Liquidity (Liability) Management Strategies

The borrowed liquidity strategy, called purchased liquidity or liability management, calls for borrowing immediately spendable funds to cover all anticipated demands for liquidity.

Borrowing liquid funds has a number of advantages:

• A financial firm can choose to borrow only when it actually needs funds, unlike storing liquidity in assets where a storehouse of liquid assets must be held at all times.
• Using borrowed funds permits a financial institution to leave the volume and composition of its asset portfolio unchanged if it is satisfied with the assets it currently holds. In contrast, selling assets to provide liquidity for liability-derived demands shrinks the size of a financial firm as its asset holdings decline.
• Liability management comes with its own control lever – the interest rate offered to borrow funds. If the borrowing institution needs more funds, it raises its offer rate until the required amount of funds flow in. If less funds are required, the offer rate is lowered.

The popular options available for the borrowed liquidity strategy are:

• Federal funds borrowings – These are reserves from other lenders that can be accessed immediately.
• Selling liquid, low-risk securities under a repurchase agreement (RP) to financial institutions having temporary surpluses of funds. RPs generally carry a fixed rate of interest and maturity.
• Issuing jumbo ($100,000+) negotiable CDs to major corporations, governmental units, and wealthy individuals for periods ranging from a few days to several months.
• Issuing Eurocurrency deposits to multinational banks and other corporations.
• Securing advances from the Federal Home Loan Bank (FHLB) system, which provides loans to institutions lending in the real-estate-backed loan market.
• Borrowing reserves from the discount window of the central bank (such as the Federal Reserve or the Bank of Japan)—usually available within a matter of minutes.

The challenges with this approach are:

• Borrowing liquidity is the most risky approach to solving liquidity problems (even though it carries the highest expected return) because of the volatility of interest rates and the rapidity with which the availability of credit can change.
• Often, financial-service providers must purchase liquidity when it is most difficult to do so, both in cost and availability.
• Borrowing cost is always uncertain, which adds greater uncertainty to earnings.
• Moreover, a financial firm that gets into trouble is usually most in need of borrowed liquidity, particularly because knowledge of its difficulties spreads and customers begin to withdraw their funds. At the same time, other financial firms become less willing to lend to the troubled institution due to the risk involved.

3) Balanced Liquidity Management Strategies

Due to the risks inherent in relying on borrowed liquidity and the costs of storing liquidity in assets, most financial firms compromise by using both asset and liability management. Under a balanced liquidity management strategy, some of the expected demands for liquidity are stored in assets (principally holdings of marketable securities), while other anticipated liquidity needs are backstopped by advance arrangements for lines of credit from potential suppliers of funds. Unexpected cash needs are typically met from near-term borrowings. Longer-term liquidity needs can be planned for, and the funds to meet these needs can be parked in short-term and medium-term assets that will provide cash as those liquidity needs arise.

Guidelines For Liquidity Managers

• Over the years, liquidity managers have developed several rules that often guide their activities:
  • First, the liquidity manager must keep track of the activities of all departments using and/or supplying funds.
  • Second, those responsible for liquidity management should know in advance when the biggest credit or funds-supplying customers plan to withdraw their funds or add funds to their accounts. This allows management to plan ahead to deal more effectively with emerging liquidity surpluses and deficits.
  • Third, the liquidity manager must make sure the financial firm’s priorities for liquidity management are clear.
  • Fourth, liquidity needs must be analyzed on a continuing basis to avoid both excess and deficit liquidity positions. Excess liquidity not reinvested the day it occurs results in lost income, while liquidity deficits must be dealt with quickly to avoid dire emergencies where the hurried borrowing of funds or sale of assets results in excessive losses.

Estimating Liquidity Needs

• Several methods have been developed in recent years for estimating a financial institution’s liquidity requirements. These methods include:

1. Sources and uses of funds approach
2. Structure of funds approach
3. Liquidity indicator approach
4. Market signals (or discipline) approach

Each method rests on specific assumptions and yields only an approximation of actual liquidity requirements. This is why a liquidity manager must always be ready to fine-tune estimates of liquidity requirements as new information becomes available. Most financial firms make sure their liquidity reserves include both a planned component, consisting of the reserves called for by the latest forecast, and a protective component, consisting of an extra margin of liquid reserves over those dictated by the most recent forecast.

I. The Sources and Uses of Funds Approach

This method for estimating liquidity considers two simple facts for banks:

• Liquidity rises as deposits increase and loans decrease.
• Alternatively, liquidity declines when deposits decrease and loans increase.

Whenever sources and uses of liquidity do not match, there is a liquidity gap, measured by the size of the difference between sources and uses of funds. When sources of liquidity (e.g., increasing deposits or decreasing loans) exceed uses of liquidity (e.g., decreasing deposits or increasing loans), the financial firm will have a positive liquidity gap (surplus). Conversely, when uses exceed sources, a financial institution faces a negative liquidity gap (deficit).

The key steps in the sources and uses of funds approach, using a bank as an example, are:

1. Loans and deposits must be forecast for a given planning period.
2. The estimated change in loans and deposits must be calculated for that same period.
3. The liquidity manager must estimate 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).

Banks use a variety of statistical techniques, supplemented by management’s judgment and experience, to prepare forecasts of deposits and loans. For example, a bank’s economics department or its liquidity managers might develop the following forecasting models:

• Estimated change in total loans for the coming period is a function of:
  • Projected growth in the economy (e.g., growth of GDP or business sales).
  • Projected quarterly corporate earnings.
  • Current rate of growth in the money supply.
  • Projected prime loan rate minus the commercial paper rate or CD rate.
  • Estimated rate of inflation.
• Estimated change in total deposits for the coming period is a function of:
  • Projected growth in personal income in the economy.
  • Estimated increase in retail sales.
  • Current rate of growth of the money supply.
  • Projected yield on money market deposits.
  • Estimated rate of inflation.

Using the forecasts of loans and deposits generated by the above models, management could then estimate the bank’s need for liquidity by calculating:

Estimated liquidity deficit (-) or surplus (+) Estimated change in deposits − Estimated change in loans = Estimated change in deposits – Estimated change in loans

A simpler approach for estimating future deposits (or other funds sources) and loans (or other funds uses) is to divide the forecast of future deposit and loan growth into three components:

1. A trend component, estimated by constructing a trend (constant-growth) line using reference points such as year-end, quarterly, or monthly deposit and loan totals established over at least the last 10 years (or some other sufficiently long base period).
2. A seasonal component, measuring how deposits (or other funds sources) and loans (or other funds uses) are expected to behave in any given week or month due to seasonal factors, compared to the most recent year-end deposit or loan level.
3. A cyclical component, representing positive or negative deviations from a bank’s total expected deposits and loans (measured by the sum of trend and seasonal components), depending upon the strength or weakness of the economy in the current year.

II. The Structure of Funds Approach

In the first step of the structure of funds approach, deposits and other funds sources are divided into categories based upon their estimated probability of being withdrawn and, therefore, lost to the financial firm. For example, a bank’s deposit and non-deposit liabilities might be divided into three categories:

• a) “Hot money” liabilities (often called volatile liabilities) – Deposits and other borrowed funds (such as federal funds borrowings) that are 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, perhaps 25 to 30 percent, will probably be withdrawn sometime during the current period.
• c) Stable funds (often called core deposits or core liabilities) – Funds that management considers unlikely to be removed (except for a minor percentage of the total).

Second, the liquidity manager must set aside liquid funds according to some desired operating rule for each of these funds sources. For example, the manager may decide to set up a 95 percent liquid reserve behind all hot money funds (less any required legal reserves held behind hot money deposits). This liquidity reserve might consist of holdings of immediately spendable deposits in correspondent institutions plus investments in Treasury bills and repurchase agreements where the committed funds can be recovered in minutes or hours. A common rule for vulnerable deposit and non-deposit liabilities is to hold a fixed percentage of their total amount in liquid reserves, say, 30 percent. For stable (core) funds sources, a liquidity manager may decide to place a small proportion of their total in liquid reserves, perhaps 15 percent or less. Thus, the liquidity reserve behind deposit and non-deposit liabilities would be:

\(\text{Liability liquidity reserve (LLR)} = 0.95 \times (\text{Hot money deposits and non deposit funds} – \text{Legal reserves held}) + 0.30 \times (\text{Vulnerable deposit and non deposit funds} – \text{Legal reserves held}) + 0.15 \times (\text{Stable deposits and non deposit funds} – \text{Legal reserves held})\)

In the case of loans, a lending institution must be ready at all times to make good loans, that is, to meet the legitimate credit needs of customers who satisfy the lender’s loan quality standards. Combining both loan and deposit liquidity requirements, this institution’s total liquidity requirement would be:

\(\text{Total liquidity requirement} = 0.95 \times (\text{Hot money deposits and non deposit funds} – \text{Legal reserves held}) + 0.30 \times (\text{Vulnerable deposit and non deposit funds} – \text{Legal reserves held}) + 0.15 \times (\text{Stable deposits and non deposit funds} – \text{Legal reserves held}) + 1.00 \times (\text{Potential loans outstanding} – \text{Actual loans outstanding})\)

The deposit and loan liquidity requirements that make up the above equation are subjective estimates that rely heavily on management’s judgment, experience, and attitude toward risk.

Many financial firms like to use probabilities in deciding how much liquidity to hold. Under this refinement of the structure of funds approach, the liquidity manager will want to define the best and the worst possible liquidity positions his or her financial institution might find itself in and assign probabilities to each. For example,

• The worst possible liquidity position- This is the situation where deposit growth at the financial firm falls below management’s expectations, so that actual deposit totals sometimes go below the lowest points on the firm’s historical minimum deposit growth track. Further, loan demand rises significantly above management’s expectations, so that loan demand sometimes goes beyond the high points of the firm’s loan growth track.
• The best possible liquidity position – This is the situation where deposit growth turns out to be above management’s expectations, so that it touches the highest points in the financial institution’s deposit growth record. Moreover, loan demand turns out to be below management’s expectations, so that loan demand grows along a minimum path that touches low points in the financial firm’s loan growth track.
• Highest probability scenario – The most likely outcome lies somewhere between these extremes.

III. Liquidity Indicator Approach

Many financial-service institutions estimate their liquidity needs based on experience and industry averages. This often involves using certain liquidity indicator ratios. For example, for depository institutions, the following liquidity indicator ratios are often useful:

1. Cash position indicator: \(\frac{\text{Cash and deposits due from depository institutions}}{\text{total assets}}\) where a greater proportion of cash implies the institution is in a stronger position to handle immediate cash needs.
2. Liquid securities indicator: \(\frac{\text{U.S. government securities}}{\text{total assets}}\)

   which compares the most marketable securities an institution can hold with the overall size of its asset portfolio; the greater the proportion of government securities, the more liquid the depository institution’s position tends to be.

3. Net federal funds and repurchase agreements position: Federal funds sold and reverse repurchase agreements−Federal funds purchased and repurchase agreementsTotal assets\frac{\text{Federal funds sold and reverse repurchase agreements} – \text{Federal funds purchased and repurchase agreements}}{\text{Total assets}}Total assetsFederal funds sold and reverse repurchase agreements−Federal funds purchased and repurchase agreements​Liquidity tends to increase when this ratio rises.
4. Capacity ratio:Net loans and leasesTotal assets\frac{\text{Net loans and leases}}{\text{Total assets}}Total assetsNet loans and leases​This is a negative liquidity indicator because loans and leases are illiquid assets.
5. Pledged securities ratio:Pledged securitiesTotal security holdings\frac{\text{Pledged securities}}{\text{Total security holdings}}Total security holdingsPledged securities​A higher ratio indicates fewer securities available to sell when liquidity needs arise.
6. Hot money ratio: \(\frac{\text{Money market (short-term) assets}}{\text{volatile liabilities}} = \frac{(\text{Cash and due from deposits held at other depository institutions} + \text{holdings of short-term securities} + \text{Federal funds loans} + \text{reverse repurchase agreements})}{(\text{large CDs} + \text{Eurocurrency deposits} + \text{Federal funds borrowings} + \text{repurchase agreements})}\)
   A ratio that reflects whether the institution has roughly balanced the volatile liabilities it has issued with the money market assets it holds that could be sold quickly to cover those liabilities.
7. Deposit brokerage index: \(\frac{\text{Brokered deposits}}{\text{total deposits}}\) where brokered deposits consist of packages of funds (usually $100,000 or less to gain the advantage of deposit insurance) placed by securities brokers for their customers with institutions paying the highest yields. Brokered deposits are interest sensitive and may be quickly withdrawn; the more a depository institution holds, the greater the chance of a liquidity crisis.
8. Core deposit ratio: \(\frac{\text{Core deposits}}{\text{Total assets}}\)
   where core deposits include total deposits less all deposits over $100,000.​Core deposits are primarily small-denomination checking and savings accounts that are considered unlikely to be withdrawn on short notice and so carry lower liquidity requirements.
9. Deposit composition ratio: \(\frac{\text{Demand deposits}}{\text{Time deposits}}\) where demand deposits are subject to immediate withdrawal via check writing, while time deposits have fixed maturities with penalties for early withdrawal. ​This ratio measures how stable a funding base each institution possesses; a decline suggests greater deposit stability and a lesser need for liquidity.
10. Loan commitments ratio: \(\frac{\text{Unused loan commitments}}{\text{Total assets}}\) which measures the volume of promises a lender has made to its customers to provide credit up to a prespecified amount over a given time period. These commitments will not appear on the lender’s balance sheet until a loan is actually “taken down” (i.e., drawn upon) by the borrower. Thus, with loan commitments there is risk as to the exact amount and timing when some portion of loan commitments become actual loans. The lender must be prepared with sufficient liquidity to accommodate a variety of “takedown” scenarios that borrowers may demand. A rise in this ratio implies greater future liquidity needs.

IV. Signals from the Marketplace

Many analysts believe there is one ultimately sound method for assessing an institution’s liquidity needs: the discipline of the financial marketplace. No financial-service provider can tell for sure if it has sufficient liquidity until it has passed the market’s test. For example, liquidity managers should closely monitor the following market signals:

1. Public confidence – Is there evidence the institution is losing money because individuals and institutions believe there is some danger it will be unable to meet its obligations on time?
2. Stock price behavior – Is the corporation’s stock price falling because investors perceive the institution has an actual or pending liquidity crisis?
3. Risk premiums on CDs and other borrowings – Is there evidence the institution is paying higher interest rates on its offerings of time and savings deposits due to a perceived liquidity crisis?
4. Loss sales of assets – Has the institution recently been forced to sell assets in a hurry, with significant losses, to meet demands for liquidity?
5. Meeting commitments to credit customers – Have liquidity pressures compelled management to turn down some otherwise acceptable credit applications?
6. Borrowings from the central bank – Has the institution been forced to borrow in larger volume and more frequently from the central bank?

If the answer to any of these questions is yes, management needs to examine its liquidity management policies and practices.

Legal Reserves And Money Position Management

• Most large depository institutions have designated an officer of the firm as the money position manager. Smaller banks and thrifts often hand this job over to larger depositories with whom they have a correspondent relationship (that is, those that hold deposits to help clear checks and meet other liquidity needs). The manager of the money position is responsible for ensuring that his or her institution maintains an adequate level of legal reserves. For example, in the US, a qualified depository institution must hold the required level of legal reserves in the form of vault cash and, if this is not sufficient, in the form of deposits held in a reserve account at the Federal Reserve bank in the region. Smaller depository institutions and banks that are not members of the Federal Reserve system may be granted permission to hold their legal reserve deposits with a Fed-approved institution. The very smallest U.S. depository institutions (holding about $10.7 million of reservable deposits in 2010) are exempt from any legal reserve requirements at all. This zero exemption is adjusted each year to help reduce the impact of inflation on deposit growth.

Regulations on Calculating Legal Reserve Requirements

• Under the current system of accounting for legal reserves—called lagged reserve accounting (LRA)—the daily average amount of deposits and other reservable liabilities is computed using information gathered over a two-week period stretching from a Tuesday through a Monday two weeks later. This interval of time is known as the reserve computation period.
• The daily average amount of vault cash each depository institution holds is also calculated over the same two-week computation period. For large institutions, another cycle begins immediately. After this, the money position manager must maintain that required legal reserve on deposit with the Federal Reserve bank in the region (less the amount of daily average vault cash held) over a 14-day period stretching from a Thursday through a Wednesday. This is known as the reserve maintenance period. This period begins 30 days after the start of the reserve computation period for deposits and other reservable liabilities. Using LRA, the money position manager has a 16-day lag following the computation period and preceding the maintenance period. This period provides time for money position managers to plan.

Reserve Requirements

• The amount of reserve requirements depends on the volume and mix of each institution’s deposits and also on the particular time period, because the amount of deposits subject to legal reserve requirements changes each year. For example, in 2010, transaction deposits had a reserve requirement of 3% of end-of-day daily average amounts for a two-week period for deposit totals between $10.7 million and $58.8 million, and a requirement of 10% on amounts above $58.8 million. This $58.8 million figure is called the reserve tranche and is adjusted annually based on the annual deposit growth rate.

Calculating Required Reserves

• Each reservable liability item is multiplied by the stipulated reserve requirement percentage to derive each depository’s total legal reserve requirement. Thus:

\(\text{Total required legal reserves} = (\text{Reserve requirement on transaction deposits} \times \text{Daily average amount of net transaction deposits over the computation period}) + (\text{Reserve requirement on nontransaction reservable liabilities} \times \text{Daily average amount of nontransaction reservable liabilities over the computation period})\)

Clearing Balances

• In addition to holding a legal reserve account at the central bank, many depository institutions also hold a clearing balance with the Fed to cover any checks or other debit items drawn against them. In the United States, any depository institution using the Federal Reserve’s check-clearing facilities must maintain a minimum-sized clearing balance—an amount set by agreement between each institution and its district Federal Reserve bank.
• Clearing balance rules work much like legal reserve requirements, with depository institutions required to maintain a minimum daily average amount in their clearing account over the same two-week maintenance period as applies to legal reserves. When they fall below the minimum balance required, they must provide additional funds to bring the balance up to the promised level. If a clearing balance has an excess amount in it, this can act as an extra cushion of reserves to help a depository institution avoid a deficit in its legal reserve account.

Factors Influencing The Money Position

A depository institution’s money position is influenced by a long list of factors, some of which are included in the following table. Some of these factors are largely controllable by management, while others are essentially noncontrollable, and management needs to anticipate and react quickly to them.

Controllable Factors Increasing Legal Reserves	Controllable Factors Decreasing Legal Reserves
• Selling Securities	• Purchasing securities
• Receiving interest payments on securities.	• Making interest payments to investors holding the bank’s securities.
• Borrowing reserves from the Federal Reserve bank.	• Repaying a loan from the Federal Reserve bank.
• Purchasing Federal funds from other banks.	• Selling Federal funds to other institutions in need of reserves.
• Selling securities under a repurchase agreement (RP).	• Security purchases under a repurchase agreement (RP).
• Selling new CDs, Eurocurrency deposits, or other deposits to customers.	• Receiving currency and coin shipments from the Federal Reserve bank.

NonControllable Factors Increasing Legal Reserves	NonControllable Factors Decreasing Legal Reserves
• Surplus position at the local clearinghouse due to receiving more deposited checks in its favor than checks drawn against it.	• Deficit position at the local clearinghouse due to more checks drawn against the bank than in its favor.
• Credit from cash letters sent to the Fed, listing drafts received by the bank.	• Calls of funds from the bank’s tax and loan account by the U.S. Treasury.
• Credit received from the Federal Reserve bank for checks previously sent for collection (deferred availability items).	• Debits received from the Federal Reserve bank for checks drawn against the bank’s reserve account.
• Deposits made by the U.S. Treasury into a tax and loan account held at the bank.	• Withdrawal of large deposit accounts, often immediately by wire.

Factors In Choosing Different Sources Of Reserves

• In choosing which source of reserves to draw upon to cover a legal reserve deficit, money position managers must carefully consider several aspects of their institution’s need for liquid funds:

1. Immediacy of need
   • If a reserve deficit comes due within minutes or hours, the money position manager will normally tap the Federal funds market for an overnight loan or contact the central bank for a loan from its discount window. In contrast, a depository institution can meet its nonimmediate reserve needs by selling deposits or assets, which may require more time to arrange than immediately available borrowings normally do.
2. Duration of need
   • If the liquidity deficit is expected to last for only a few hours, the Federal funds market or the central bank’s discount window is normally the preferred source of funds. Liquidity shortages lasting days, weeks, or months, on the other hand, are often covered with sales of longer-term assets or longer-term borrowings.
3. Access to the market for liquid funds
   • Not all depository institutions have access to all funds markets. For example, smaller depositories cannot, as a practical matter, draw upon the Eurocurrency market or sell commercial paper. Liquidity managers must restrict their range of choices to those their institution can access quickly.
4. Relative costs and risks of alternative sources of funds
   • The cost of each source of reserves changes daily, and the availability of surplus liquidity is also highly uncertain. Other things being equal, the liquidity manager will draw on the cheapest source of reliable funds, maintaining constant contact with the money and capital markets to be aware of how interest rates and credit conditions are changing.
5. The interest rate outlook
   • When planning to deal with a future liquidity deficit, the liquidity manager wants to draw upon those funds sources whose interest rates are expected to be the lowest.
6. Outlook for central bank monetary policy
   • Closely connected to the outlook for interest rates is the outlook for changes in central bank monetary policy, which shapes the direction and intensity of credit conditions in the money market. For example, a more restrictive monetary policy implies higher borrowing costs and reduced credit availability for liquidity managers.
7. Rules and regulations applicable to a liquidity source
   • Most sources of liquidity cannot be used indiscriminately; the user must conform to the rules. For example, borrowing reserves from a central bank frequently requires the borrowing institution to provide collateral behind the loan.