Saturday, August 8, 2009

conversion-of-funds approach

Competition from nonbank depository institution fostered a change in the structure of bank liabilities, as did the innovations in the sources of bank funds: CDs Eurodollars, repurchase agreements, Consequently,the pool-of-funds approach became less tenable; it became unrealistic to view bank sources of funds as being a common pool of funds with similar characteristic. Each source had a unique volatility, cost, and legal reserve requirement. Moreover, the upward trend in interest rates induced bankers to become efficient reserve managers. the conversion-of-funds approach treats each source of funds individually and matches each source of funds with an asset that has a similar maturity. Demand deposits (which have a high legal reserve requirement and a rapid turnover) are allocated quite differently from funds generated by the bank ‘S sale of long-term bonds. For example, a large proportion of demand deposits are allocated to primary and secondary reserve, while bank bond sales are used to finance long-term loans and fixed assets.
the main advantage of this approach is that it emphasizes profitability, not liquidity. In effect, it reduces the average value of liquid reserves and increases the allocation of funds to loans and investments.
Nevertheless, some problems remain.liquidity needs are overestimated if one equates deposit turnover (which is indeed high) with deposit volatility (which need to be high if a lot of deposit turnover is self-canceling). second, the loan portfolio is still assumed to be illiquid. finally, this approach does not sufficiently stress that asset and liability decisions are interdependent.

No comments: