18 - Chapter Eighteen Liability and Liquidity Management...

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Chapter Eighteen Liability and Liquidity Management Chapter Outline Introduction Liquid Asset Management Monetary Policy Implementation Reasons Taxation Reasons The Composition of the Liquid Asset Portfolio Return-Risk Trade-Off for Liquid Assets The Liquid Asset Reserve Management Problem for U.S. Depository Institutions Undershooting/Overshooting of the Reserve Target Liability Management Funding Risk and Cost Choice of Liability Structure Demand Deposits Interest-Bearing Checking (NOW) Accounts Passbook Savings Money Market Deposit Accounts (MMDAs) Retail Time Deposits and CDs Wholesale CDs Federal Funds Repurchase Agreements (RPs) Other Borrowings Liquidity and Liability Structures for U.S Depository Institutions Liability and Liquidity Risk Management in Insurance Companies Liability and Liquidity Risk Management in Other FIs Summary 211
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Solutions for End-of-Chapter Questions and Problems: Chapter Eighteen 1. What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Treasury securities considered good examples of liquid assets? A major benefit of an FI holding a large amount of liquid cash is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking conservative positions by holding large amounts of liquid assets will therefore have lower profits. Treasury securities are considered good examples of liquid assets because they can be converted into cash quickly with very little loss of value from current market levels. 2. How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities? For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event liabilities began to leave the FI or to be not reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire sale prices. These prices would tend to deviate farther from the market value as the maturity of the assets increased. Thus the FI may sustain larger losses. 3. Consider the assets (in millions) of two banks, A and B. Each bank is funded by $120 million in deposits and $20 million in equity. Which bank has the stronger liquidity position? Which bank probably has a higher profit? Bank A Asset
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This note was uploaded on 10/25/2010 for the course FIN 398 taught by Professor Ray,jackson during the Spring '10 term at UMass Dartmouth.

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18 - Chapter Eighteen Liability and Liquidity Management...

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