27. Bank liquidity: notion, analysis, regulation.

A bank is considered to be liquid if it has ready access to immediately spendable funds at reasonable cost at precisely time those funds are needed. This means the bank either has the right amount of immediately spendable funds on hand or can raise the necessary funds by borrowing or by selling assets.

Demands for bank liquid typically arise from customers withdrawing funds on deposits; credit requests from quality loan customers; repayment of non deposit borrowings and miscellaneous liabilities, operating expenses incurred in producing and selling services; payment of stockholder cash dividends.

Supply of liquid funds come from incoming customers deposits; revenues from the sale of non-deposit services; customer loan repayments; sales of bank assets, borrowings from the money market.

Bank liquidity rises as a result of deposit increases and\or decreases in loans outstanding and bank liquidity declines when deposits decrease and/or loans increase.

The key steps in the sources-and-funds approach are:

Loans and deposits must be forecast for a given liquidity planning period.

The estimated change in loans and deposits must be calculated for that of planning period.

LIQUIDITY MANAGEMENT The liquidity manager must estimate the bank’s net liquid funds, surplus or defecit, for the planning period. The process of bank liquidity regulation consists of a set of methods and actions to manage assets and liabilities. There are 4 groups of assets management:

1. Money resources, which are available in the bank (money on the correspondent accounts, Obligatory reserve funds of the central bank of Russia), money invested in assets which can be easily turned to cash during short period of time (State securities; short-term loans, guaranteed by the Government) and placing correspondent deposits with other banks –these interbank deposits can be borrowed or loaned in minutes, but until they are needed, interbank deposits provide interests earning and help to compensate other banks for the services they provide, such as check clearing, portfolio management advice.

2. Loans to other institutions- loans of banks reserves for the short time period in order to cover temporary cash deficit.. The level of liquidity of these assets depends on the terms and the aims, as well as on the borrowers. The more liquidity loans are the loans given to others banks and short-term loans to the first-class borrowers. Commercial papers- short-term claim against a bank arising from credit extended to a customer, coming due normally within 6 months or less, and having an active resale market through dealers.

3. Investments in the securities of other companies. The level of liquidity in this group is significantly lower than in the previous. The more wide-spread liquidity assets are banks’ securities (certificates of deposits, shares)

4. The main bank’s funds: buildings, equipments, transports-the lowest liquidity assets, but it is necessary to take into consideration the concrete economic situation in the country.

The volume and structure of the assets in relation to the particular articles of the balance is defined by those sources by which they are formed: liabilities. The predominant part of bank’s liabilities amounting to 90% or higher makes up the funds of clients (companies, organizations, private persons). The rest is the own funds (equity): authorized capital stock, funds of special purpose, and retained income.

Liquidity management searchs for the borrowing funds and with subsequent choice of the most reliable and with longest terms of attractions and the establishment of the necessary optimal correlation between particular types of assets and liabilities, allowing a bank always to fulfill the creditors’ obligations.. That is why the processes of assets and liabilities management are interrelated, interdependent and exercised simultaneously.

The joint fund method (метод общего фонда средств): all kinds of resources (deposit accounts, balances on deposits, authorized capital stock and reserves) are joined in the aggregate fund of resources. These resources are distributed, ensuring the balance “profitability-liquidity”, among the assets that are considered to be the more acceptable from the profit point of view. This fund is divided into some parts to be allocated into assets according to its of liquidity (4 группы активов см. выше).

Asset conversion method (метод конверсии средств): liquid funds are raised by converting non-cash assets into cash, selected assets will be sold for cash until all the bank’s demands for cash are met. In accordance with this method some liquidity centers (banks inside the bank) are established. In particular, so-called centers consist of the deposit on call, deposit accounts and deposits, authorized capital and reserves. The resources from each center can be allocated only in the definite assets, to support corresponding liquidity and profitability.

28. Classification of bank operations.

Active operations – bank act as lender (loans, credits), passive – like deposits – just operations without loaning. Some transactions may be both passive and active.

(1).Loans

The principal business of banks is to make loans to qualified borrowers. Loans are among the highest yielding assets a bank can add to its portfolio (60-70 %), and they pro­vide the largest portion of operating revenue.

It is possible to define: inter bank loans, corporate loans and individual loans. By the way, in Russia individual loans are becoming more and more popular.

A substantial portion of bank credit (nearly 20 percent of all bank assets) is extended to commercial and industrial customers in the form of direct loans. Historically, commercial banks have preferred to make short-term loans to busi­nesses, principally to support purchases of inventory. In recent years, however, banks have lengthened the maturity of their business loans to include term loans (which have maturities over one year) to finance the purchase of buildings, machinery, and equip­ment. Because these longer-term loans carry greater risk due to unexpected changes in interest rates, banks have also required a much greater proportion of new loans to carry variable interest rates that can be changed with shifting market conditions.

Moreover, longer-term loans to business firms have been supplanted to some extent in recent years by equipment leasing plans available from larger banks and the sub­sidiaries of bank holding companies. These leases are the functional equivalent of a loan: the customer not only makes the required lease payments for using the equipment but also is responsible for repairs and maintenance and for any taxes due. Lease financing carries not only significant cost and tax advantages for the customer but also substantial tax advantages for a bank because it can depreciate leased equipment.

Commercial banks are also important lenders in the real estate field, supporting the construction of residential and commercial structures. Major types of loans in the real estate category include farm real estate credit, conventional government-guaranteed (FHA and VA) single-family residential loans, conventional and government-guaranteed loans on multifamily residences (such as apartments), and mortgage loans on nonfarm commercial properties. Indeed, commercial banks are the most important source of con­struction financing in the economy.

Probably the most dynamic area in bank lending today is the making of installment loans to individuals and families, particularly loans secured by a property owner's equity in his or her home, so-called home equity loans, whose interest costs are tax deductible to the home owner and borrower. Home equity loans can be used to finance a college edu­cation or to pay down other debts, or they can be used for a variety of needs not related to housing. The number of new households has expanded rapidly in recent years, and commercial banks have moved to answer this need by offering longer maturities on installment loans and new types of credit arrangements, especially credit-card loans. Banks finance the purchase of automobiles, home furnishings, and appliances and pro­vide funds to modernize homes and properties and to pay for education and travel.

(2). Securities transactions (bonds, shares, promissory notes, bills of exchange)

Features in Russia: - small number of issuers (approx. 20); - these securities are undervalued; - emerging market, high risks; - political risk: bank rank cannot be higher than the rank of a country.

(3). Inter bank deposits.

Deposits

To carry out their extensive lending and investing operations, banks draw on a wide variety of deposit and nondeposit sources of funds. The bulk of commercial bank funds— about three fourths of the total—comes from deposits. There are three main types of deposits. Demand deposits, more commonly known as checking accounts, are the princi­pal means of making payments because they are safer than cash and widely accepted. Savings deposits generally are in small dollar amounts; they bear a relatively low interest rate but may be withdrawn by the depositor with no notice. Time deposits carry a fixed maturity and offer the highest interest rates a bank can pay. Time deposits may be divid­ed into nonnegotiable certificates of deposit (CDs), which are usually small, consumer-type accounts, and negotiable CDs that may be traded in the open market in million-dol­lar amounts and are purchased mainly by corporations.

During the 1970s and 1980s, new forms of checkable (demand) deposits appeared, combining the essential features of both demand and savings deposits. These transac­tion accounts include negotiable orders of withdrawal (NOWs) and automatic transfer services (ATS). NOW accounts may be drafted to pay bills but also earn interest; ATS is a preauthorized payment service in which the bank transfers funds from an interest-bear­ing savings account to a checking account as necessary to cover checks written by the customer. Two relatively new transaction accounts —money market deposit accounts (MMDAs) and Super NOWs—were first offered in 1983. MMDAs, designed to compete directly with the high-yielding share accounts offered by money market mutual funds, and Super NOWs may carry prevailing market rates on short-term funds and can be drafted by check, automatic withdrawal, or telephone transfer.

The mix of bank deposits has changed dramatically in recent years. Demand deposits and low-yield savings deposits have declined as a percentage of bank funds while more costly interest-bearing accounts such as MMDAs have grown rapidly. These newer deposits are generally market-linked accounts whose returns are tied to move­ments in interest rates and security prices, reflecting prevailing credit conditions in the financial system. Banks are well aware today that their customers are more financially sophisticated and have a greater tendency to "shop around" for the highest returns available on both transaction and savings deposits. As a result, the average real cost of bank deposits probably has increased over time.

Moreover, the cost of attracting customer funds has been further increased in recent years by the tendency of bankers to expand their services in an effort to offer their customers "one-stop" financial convenience. Thus, to retain old deposits and attract new ones, many banks have developed or are working through franchise agree­ments to offer (1) security brokerage services so that customers can purchase stocks and bonds and pay by charging their deposit accounts; (2) insurance counters to make life, health, and property-casualty insurance coverage available (usually through joint ventures with cooperating nonbank firms); (3) networking agreements with other banks so that customers can access their deposit accounts while traveling; (4) account reloca­tion services and real estate brokerage of homes and other properties for customers who move; (5) financial and tax counseling centers to aid customers with important personal and business decisions; and (6) merchant banking services that aid major corporations with mergers and long-term financing requirements. Bankers are also pushing Congress and the regulatory agencies-for broad permission to offer investment banking ser­vices—purchasing corporate securities issued by their business customers and reselling them to investors. These new services may have opened up new markets for banks, but they have also created new complexities for bank management and demanded greater efficiency and more effective marketing techniques.