Question

Question 1
(a) Explain purchased liquidity approach in liquidity management and point out 2 advantages of that

approach. (b) Explain stored liquidity approach in liquidity management and point out 2 advantages of that

approach. (c) An FI has 2 kinds of assets: 60% in 1 month T-bill and 40% in 1 month consumer loan. In a month, the T-bill will yield $100, but now it worths only $97. The consumer loan will yield $88 in a month, but now it is worth $76. Calculate the 1 month liquidity index.

4. (d) Refer to (c), if the market conditions change suddenly and the T-bill now worths $98, while the

   consumer loan worths $72. Calculate the new 1 month liquidity index.

5. (e) Based on the results from (c) and (d), interpret the liquidity risk faced by the FI before and after the

Answer 1

(a) Purchase Liquidity Approach

•Liquidity can be purchased in financial markets, e.g. borrowed funds from other banks and other institutional investors.

–Federal funds market in the U.S. and the repurchase agreement market

•Benefit:- preserving asset side of balance sheet.

•Downsides: –Borrowed funds are likely to be at higher rates than interest paid on deposits, i.e. funds to be borrowed at market rates.

–Deposits are insured but borrowed funds not necessarily protected

–Funding risk is high, especially during credit crisis period.

(b) Stored Liquidity Approach

•Maintain sufficient liquid assets on the balance sheet.

•Liquidate assets when needed

–If there is no reserve requirement, banks tend to hold excess reserve assets.

•Downside

–opportunity cost of holding excessive liquid assets

–Decreases size of balance sheet by liquidating assets to meet liquidity needs

–Low returns.