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Test 3 study guide - Chapter 18-Liquidity and Liquidity...

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Chapter 18-Liquidity and Liquidity Management Liquidity Risk -Depository institutions are highly exposed to liquidity risk -They can insulate their balance sheets from liquidity risk by: -Efficiently managing their liquid asset positions. -Managing the liability structure of their portfolios. -Both Liquidity Asset Management -Goal is to make sure FIs have enough liquid assets to meet expected/unexpected needs -examples of liquid assets: t-bills/notes, cash, reserves at FR banks -usually bear low returns b/c they have low risk so they can remain liquid -FI’s face a trade-off because they will have decreased expected returns -FR banks pay low int. rate on reserves b/c of the crisis and liquidity problems Monetary Policy -multiplier effect of changes in reserve requirements -monetary policy no longer tries to control the money supply Taxation -due to absence of interest on reserves, requiring reserves constitutes transfer of a resource to the central bank...which is not really a social benefit Return-Risk Trade-Off -Trade-off: cash immediacy vs. lower returns -Constrained optimization: maximize profits subject to a minimum amount of liquid assets that corresponds to the “maximum permissible risk” -max permiss. risk might differ between regulators and banks->privately optimal reserve holdings are not the same as regulator’s optimal reserve holdings -Transactions accounts: deposits that permit the account holder to make essentially unlimited withdrawals i.e. demand deposits, NOW accounts Reserve Management Problem -To calculate target amount of reserves, the FI needs 2 pieces of info: 1. on what period’s deposits does the manager compute the reserve requirement? (res.
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computation period) 2. For which period must the FI maintain the reserves? (reserve maintenance period) -these periods are 14 days each but occur at different times -lagged reserve accounting is used -makes it easier for bank reserve managers to calculate their req. reserve balances -Increases the accuracy of information on aggregate required reserve balances. Undershooting -When vault cash and reserves are less than required -4% error allowed free of penalty -if undershooting occurs, surplus reserves are required for next 2 weeks -undershooting past 4%-penalty in interest rate charge by 2% more -it attracts scrutiny by regulators -DI have 3 options to avoid it: 1. Liquidate assets and sales money into reserve account 2. Borrow reserves from other FIs 3. Borrow at the discount window from FR Discount Window -used to be highly administrated, only allowed in emergency -used to be lower discount rate than market rates -easier to borrow now, but no longer subsidized Overshooting -cash and reserves more than required -first 4% over can be carried forward to the next period -excess reserve are typically low due to opportunity costs -Knife-edge management problem: holding too many liquid assets hurts earnings and increases pressure from stockholders -if you undershoot too frequently you risk liquidity crises and regulatory penalties/intervention
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