Chapter - 9 Investment Portfolio and Liquidity Management
Chapter - 9 Investment Portfolio and Liquidity Management
Chapter - 9 Investment Portfolio and Liquidity Management
Estimated liquidity deficit (–) or surplus (+) for the coming period
= Estimated change in total deposits – Estimated change in total loans
Structure of Deposit Method
The structure of funds approach is a method for estimating a bank’s liquidity needs
by dividing its borrowed funds into categories based on their probability of
withdrawal and therefore lost to the bank. The bank’s deposit and non-deposit
liabilities divided into three categories.
First divides deposits and other funds sources into different categories depending
on the probability of withdrawals. These categories are usually as follows:
a. “Hot money” liabilities (volatile liabilities): Hot money liabilities are that
deposits and other borrowed funds that are very interest sensitive deposits and
borrowed funds that expected to be withdrawn in current period.
b. Vulnerable funds: Vulnerable funds are that deposits of substantial portion,
perhaps 25 or 30 percent is likely to be withdrawn in current period.
c. Stable funds (core deposits/liabilities): Funds that management considers
most unlikely to be withdrawn.
•Second, the liquidity manager must allocate the liquid funds for each category
of funds according to some operating rules. For example, the manager may
decide to set up a 95 percent liquid reserve behind all hot money funds (less any
reserves the bank holds behind not money deposits). This liquidity reserve might
consist of holdings of immediately spendable deposits in correspondent banks
plus investments in treasury bills and repurchase agreements where the
committed funds can be recovered in a matter of minutes or hours.
•A common rule of thumb for vulnerable deposit and non-deposit liabilities is to
hold a fixed percentage of 30 percent of their total amount in liquid reserves. For
stable (core) funds sources, the bank may decide to place a small proportion of
15 percent or less of their total in liquid reserves. Thus, the liquidity reserve
behind the bank deposit and non-deposit liabilities would be as follows:
• Liability liquidity reserve = 0.95 × (Hot money funds – Legal reserve held)
+ 0.30 × (Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds –
Legal reserves held)
•Total liquidity requirement = 0.95 × (Hot money funds – Legal reserve held) + 0.30 ×
(Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds – Legal reserves held) +
1.00 (Potential loans outstanding – Actual loans outstanding)
Liquidity indicators Approach
This approach estimate liquidity needs by relying on the use of experience and industry
averages. This approach uses different liquidity indicators ratios such as:
a. Cash position indicator: Cash and deposits due from depository institutions ÷ total assets,
where a greater proportion of cash implies the bank is in a better position to handle
immediate cash needs.
b. Liquid security indicator: Government securities ÷ total assets, which compares the most
marketable securities a bank can hold with the overall size of its asset portfolio; the greater
the proportion of government securities, the more liquid the bank’s position.
c. Net federal funds position: (federal funds sold – federal funds purchased and repurchase
agreements) ÷ total assets, which measures the comparative importance of overnight loans to
overnight borrowings of reserves. The higher the ratio, the liquidity tends to increase.
d. Capacity ratio: Net loans and leases ÷ total assets, which is really a negative liquidity
indicator because loans and leases are often among the most illiquid assets a bank can hold.
e. Pledge security ratio: Pledge securities ÷ total security holds, also a negative liquidity
indicator because the greater the proportion of securities pledged to back government
deposits, the fewer securities are available to sell when liquidity needs arise.
f. Hot money ratio: Money market assets ÷ money market liabilities = (cash + short
term government securities + federal funds loans + reverse repurchase agreements) ÷
(large CDs + Eurocurrency deposits + federal funds borrowed + repurchase
agreements). This ratio reflects whether the bank has balanced its borrowings in the
money market with increases in its money market assets that could be sold quickly to
cover those money market liabilities.
g. Deposit brokerage index: Brokered deposits ÷ 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 banks
paying the highest yields. Brokered deposits are highly interest sensitive and may be
quickly withdrawn; the more the bank holds, the greater the chance of a liquidity crisis.
h.Core deposit ratio: Core deposit ÷ total assets, where core deposits are defined as
total deposits less all deposits over $ 100,000. Core deposits are primarily small
denomination accounts from local customers that are considered unlikely to be
withdrawn on short notice and so carry lower liquidity requirements.
i. Deposit composition ratio: Demand deposits ÷ 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 bank possesses; a decline in the ratio suggests greater deposit
stability and, therefore, a lessened need for liquidity.
Market signal Approach
•This is a qualitative approach to measuring liquidity
requirement of banks. It is technique that centres on the
discipline of the financial market place, which subject banks
to series of market’s tests, such as the ability of bank to pass
the following tests:
a. Public confidence
b. Stock price behaviour
c. Risk premium on CDs and other borrowings
d. Loss sales of assets
e. Meeting commitments to credit customers
f. Borrowings from the central bank.
List of formula
1. Net liquidity position = Total Cash Inflows – Total Cash Outflows
2. Total liquidity requirement = 0.95 × (Hot money funds – Legal reserve held) +
0.30 × (Vulnerable funds – Legal reserves held) + 0.15 × (Stable funds – Legal reserves
held) + 1.00 (Potential loans outstanding – Actual loans outstanding)
3. Net liquidity surplus = liquidity supplies – Liquidity Demands – Deposit
Withdrawals
4. Liquidity indicators includes
i. Cash position indicators = (Cash and deposit due from other banks)/(Total
assets)×100
ii. Net Federal Funds position = ((Federal Funds Sold-Federal Funds
Purchase))/(Total assets)×100
iii. Capacity Ratio = ( Net Loans and lease)/(Total assets)×100
iv. Deposit Composition Ratio = (Demand Deposit)/(Time Deposit)×100
v. Liquidity Securities Indicator =(U.S Government Securities)/(Total assets)×100
Vi. Reserve Credit = Average Clearing balance × Annualized Fed. funds Rate × (Reserve
maintence period)/(Days in year i.e 360)×100