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Chapter 18 - Liability and Liquidity Management

Fin 698

Fall 2012

Prof. Anderson

HW #7b: chapter 18: 3, 10, 11, 16 and 17. (These appear in the book on pages 568-572.) Solutions for End-of-Chapter Questions and Problems 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 to an FI of holding a large amount of liquid assets 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 be able to 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 that liabilities begin to leave the FI or are 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 further from their market value as the maturity of the assets increase. Thus, the FI may sustain larger losses. 3. Consider the assets (in millions) of two banks, A and B. Both banks are 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 Cash $10 Treasury securities 40 Commercial loans 90 Total assets $140 Bank B Assets Cash Consumer loans Commercial loans Total assets $20 30 90 $140

Bank A is more liquid because it has more liquid assets than Bank B, although it has less cash. Bank B probably earns a higher profit because the return on consumer loans should be greater than the return on Treasury securities. However, comparing the loan portfolios is difficult because it is impossible to evaluate the credit risk contained in each portfolio.

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Chapter 18 - Liability and Liquidity Management

4.

What concerns motivate regulators to require DIs to hold minimum amounts of liquid assets?

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Chapter 18 - Liability and Liquidity Management

Regulators prefer DIs to hold more liquid assets because this ensures that they are able to withstand unexpected and sudden withdrawals. In addition, regulators are able to conduct monetary policy by influencing the money supply through liquid assets held by DIs. Finally, reserves held at the Fed by financial institutions also are a source of funds to regulators, since they pay little interest on these deposits. 5. How do liquid asset reserve requirements enhance the implementation of monetary policy? How are reserve requirements a tax on DIs?

In the case of DIs, reserve requirements on demand deposits allow regulators to increase or decrease the money supply in an economy. The reserve requirement against deposits limits the ability of DIs to expand lending activity. Further, reserves represent a form of tax that regulators can impose on DIs. By raising the reserve requirements, regulators cause DIs to transfer more balances into non-earning assets. This tax effect is even larger in cases where inflation is stronger. 6. Rank these financial assets according to their liquidity: cash, corporate bonds, NYSEtraded stocks, and T-bills.

The liquidity ranking from most liquid to...
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