Ch 18 fully revised 2011

Ch 18 fully revised 2011 - 1 Chapter 18 Liability &...

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1 Chapter 18 (Liquid Asset Management and Liability Management)
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2 Overview This chapter Liquid Asset Management h Return-Risk trade-off h Reserve Requirements h Calculating h Undershooting/Overshooting Liability Management h Choice of liability structure & the various instruments
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3 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
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4 Liquid Asset Management A liquid asset can be turned into cash quickly and at little or no loss in principal value. Examples: T-bills, T-notes, T-bonds, cash and reserves at Federal Reserve banks. Because of their high liquidity and low default risk, such assets often bear low returns. Hence, FIs face a trade-off in holding large quantities of liquid assets (i.e., they increase liquidity but decrease expected returns). Federal Reserve banks now pay a low interest rate on reserves since 2008 because of the financial crisis. The interest rate on required reserve balances was set equal to 25 basis points effective with the reserve maintenance periods beginning December 18, 2008.
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5 Liquid Asset Management The goal of liquid asset management is to make sure FIs have enough liquid assets to meet expected and unexpected liquidity needs (e.g., transactions deposit outflows or draws on loan commitments). Regulators also impose minimum reserve requirements on FIs. Minimum reserve requirements in the U.S. are met by holdings of vault cash and deposits at Federal Reserve banks. In general, these requirements differ in nature and scope for various FIs and according to country.
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6 Liquid Asset Management Reasons for regulating minimum holdings of liquid assets (other than managing liquidity risk): Monetary policy h Multiplier effect of changes in reserve requirements. h But they don’t change reserve requirements very often. h Used to be argued that high reserve requirement help control the money supply. h However, monetary policy no longer tries to control the money supply. Taxation h Due to absence of interest on reserves (or now low interest rate on reserves), requiring reserves constitutes transfer of a resource to the central bank. h This is not really a social benefit. h Note bank responses such as sweep programs, and the weekend game.
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7 Return-Risk Trade-Off Trade-off: cash immediacy versus lower returns. Constrained optimization: maximize profits subject to
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Ch 18 fully revised 2011 - 1 Chapter 18 Liability &...

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