Sunday, August 2, 2009

the pool-of-funds approach

after experiencing the severe liquidity crisis of the Great Depression, bankers adopted an asset-liability portfolio approach that emphasized safety over short-term profitability.additionally, demand deposits were by far the largest source of bank funds, and so such an emphasis on liquidity was further justified, because these bank liabilities were so short term. the label for this portfolio management technique is the pool-of-funds approach.
the pool-of-funds approach begins with the establishment of an overall level of desired liquidity, determined by senior management. In essence, this approach views all the bank‘s sources of funds (its liabilities) as emanating from a common pool; and this pool is considered to be determined by factors not under the bank‘s control,such as overall business activity, community income,population, and so on.
The first allocation of this pool of funds goes to primary reserves-vault cash, required deposit reserves at the district Federal Reserve bank,and balances with other depository institutions. the second allocation is to secondary reserves_ short-term, highly liquid securities. the average maturity of the secondary reserve is usually less than one year; such funds provide the bank with its primary source of liquidity under this approach.
Once sufficient liquidity has been assured, funds are allocated to finance all legitimate loan requests. Note that the asset structure, or the distribution of credit, is also viewed as a reflection of economic forces in the bank‘s geographic area; note further that the loan portfolio (the firm‘s riskier assets)is not considered a source of liquidity.
After the "legitimate" credit needs of society are met, any additional funds are used to purchase such long-term securities as treasury bonds. the objective is to provide income and to supplement secondary reserves as these securities approach maturity.
the pool-of-funds approach is not without its critics . first, there is no objective basis for estimating the "liquidity standard" second, within the pool of funds, different deposits have different volatility;no indication of the importance of these differences to overall liquidity is considered. third, the concentration is on liquidity, not profitability; but ultimately the long-run safety of abank requires adequate earnings. Fourth,it ignores the liquidity provided by the loan portfolio through the continuous flow of funds from principal and interest payments.
Finally,the pool-of-funds approach disregards the interactive character of assets and liabilities in the generation of liquidity and profit earnings.

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