Liquid Reserves Research Articles

Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises

The accumulation of large amount of sovereign reserves has fuelled an intense debate on the associated costs. In a world with liquidity crises and strategic default, we model a contracting game between international lenders and a country, which delivers the country's optimal portfolio choice and the cost of sovereign debt: at equilibrium, the sovereign allocates the borrowed resources to either liquid reserves or an illiquid and risky production project. We study how the opportunity cost of hoarding reserves is affected by the financial and technological characteristics of the economy. In line with recent empirical evidence, we find two important results: the cost of debt decreases in the level of reserves if the probability of liquidity shocks is high enough; however the cost of debt increases in reserves when the lenders anticipate that the country has an incentive to default after a liquidity shock. Indeed, we show that the country may choose to retain reserves instead of employing them to inject the liquidity needed to bring the production project to maturity.

Reserve Management and Sovereign Debt Cost in a World with Liquidity Crises

The accumulation of large amount of sovereign reserves has fuelled an intense debate on the associated costs. In a world with liquidity crises and strategic default, we model a contracting game between international lenders and a country, which delivers the country's optimal portfolio choice and the cost of sovereign debt: at equilibrium, the sovereign allocates the borrowed resources to either liquid reserves or an illiquid and risky production project. We study how the opportunity cost of hoarding reserves is affected by the financial and technological characteristics of the economy. In line with recent empirical evidence, we find two important results: the cost of debt decreases in the level of reserves if the probability of liquidity shocks is high enough; however the cost of debt increases in reserves when the lenders anticipate that the country has an incentive to default after a liquidity shock. Indeed, we show that the country may choose to retain reserves instead of employing them to inject the liquidity needed to bring the production project to maturity.

Optimal dividend strategies in a dual model with capital injections

We study three types of practical optimization problems faced by a firm that can control its liquid reserves by paying dividends and by issuing new equity. In the first problem, we consider the classical dividend problem without equity issuance. The second problem aims at maximizing the expected discounted dividend payments minus the expected discounted costs of issuing new equity over strategies associated with positive reserves at all times. The third problem has the same objective as the second one, but with no constraints on the reserves. Under the assumption of proportional transaction costs, we identify the value functions and the optimal strategies. We also present the relationship between three problems.

Consolidation and competition in the US equity markets

Strong secondary trading markets are essential to the formation of public capital. Although private investors in securities may be willing to accept some degree of limited markets in return for the opportunity to invest in a small or young company, or to earn a liquidity premium, investors that buy securities in public offerings desire strong secondary trading markets where they can readily sell their securities at low transactions costs. Strong secondary markets, with their attendant benefits of continuous liquidity and efficient prices, are desired by both small investors, who lack large liquid reserves, and by large investors, the size of whose stock positions require deep markets. Without strong secondary markets, fewer companies would be able to raise capital in the public markets, and companies accessing the public markets would find them more expensive, raising the cost of capital and lowering real investment. The US Securities and Exchange Commission (SEC) has long recognized the importance for capital raising of strong trading markets. In recent pronouncements, the SEC has said that in regulating trading markets the interests of long-term investors and Key points

Well-Test Dynamics in Rich-Gas/Condensate Reservoirs Under Gas Injection

This article, written by Senior Technology Editor Dennis Denney, contains highlights of paper SPE 121848, ’Well-Test Dynamics in Rich-Gas/Condensate Reservoirs Under Gas Injection,’ by O.A. Aluko, SPE, and A.C. Gringarten, SPE, Imperial College London, prepared for the 2009 SPE Europec/EAGE Annual Conference and Exhibition, Amsterdam, 8-11 June. Well-test behavior of rich-gas/condensate reservoirs with pressure below the dewpoint pressure was studied to analyze revaporization of the condensate bank upon repressurization by gas injection. Compositional-simulation results suggested that the near-wellbore fluid saturation below the dewpoint pressure in a buildup is different from that at the end of the preceding drawdown because of significant differences in fluid properties and saturation distributions. A method was proposed to evaluate the bank storativity, which then is used to calculate the bank radius. Introduction Rich-gas/condensate reservoirs are characterized by a high liquid-hydrocarbon yield and often are developed for their liquid reserves. Compared to lean-gas condensates, rich-gas condensates have a higher percentage of intermediates and C7+ components, higher specific gravity, and lower gas/oil-ratio (GOR). Often, guidelines used to distinguish rich-gas condensate are an initial producing GOR of 3,300 to 5,000 scf/STB, heptanes-plus concentrations of approximately 12.5%, maximum liquid drop-out up to 35%, and an initial liquid yield greater than 100 STB/MMscf. Rich-gas/condensate reservoirs challenge fluid characterization and well-test analysis because of their near-critical nature. A unique problem in reservoir development is the result of condensate deposit at pressures below the dewpoint pressure and the creation of a condensate bank that decreases productivity and may result in a potentially significant loss of liquid reserves. Rich-gas/condensate reservoirs often are developed with secondary- or enhanced-oil-recovery methods to maximize liquid recovery. It is vital to monitor and understand the behavior of the two-phase condensate bank during production when assessing its effect on productivity and ultimate recovery. Gas injection into rich-gas/condensate reservoirs attempt to maintain the average reservoir pressure (and possibly the flowing bottomhole pressure) above the dewpoint pressure. Injecting gas below the dewpoint pressure can improve condensate recovery by displacing condensed liquids toward producing wells and vaporizing the intermediate and heavy components of the condensate. As detailed in the full-length paper, time-lapse well-test-pressure derivatives can be used to monitor changing fluid saturations in these reservoirs. Well-Test Dynamics Below the Dewpoint Pressure Compositional simulation was used to investigate and characterize reservoir-fluid dynamics and well-test behavior in rich-gas/condensate reservoirs. The thermodynamic properties of the fluids were represented by modified Peng-Robinson equation of state (EOS), with EOS parameters based on experimental data from the MTGc reservoir in north Africa. Velocity-dependent parameters matched to multirate-well-test data were included in the numerical modeling. The study focused on the effects of the following.

Analysis of the Compound Poisson Surplus Model with Liquid Reserves, Interest and Dividends

AbstractThe paper incorporates liquid reserves, interest and dividends in the compound Poisson surplus model. When an insurer's surplus is below a certain level, it is kept as liquid reserves. As the surplus attains the level, the excess of the surplus above the level will earn interest at a constant interest rate. If the surplus continues to surpass a higher level, the excess of the surplus above this higher level will be paid out as dividends to the insurer's shareholders at a constant dividend rate or by the threshold strategy. The lower and higher levels are called the liquid reserve level and the threshold level, respectively.This paper is to discuss the interactions of the liquid reserve level, the interest rate, the threshold level, and the dividend rate in the proposed risk model by studying the expected discounted penalty function and the expected present value of dividends paid up to the time of ruin. We derive expressions for the solutions to both quantities via the approach of integro-differential equation systems. We show that the dividend-penalty identity (Gerber et al. 2006, ASTIN Bulletin) still holds for the threshold strategy with liquid reserves and interest. We illustrate these results by deriving explicit solutions to the probability of ultimate ruin under the threshold strategy when claim sizes are exponentially distributed. In the end, we also discuss the impact of the liquid reserve level, the interest rate, the threshold level, and the dividend rate on the ruin probability by numerical examples.

The Compound Poisson Surplus Model with Interest and Liquid Reserves: Analysis of the Gerber–Shiu Discounted Penalty Function

We modify the compound Poisson surplus model for an insurer by including liquid reserves and interest on the surplus. When the surplus of an insurer is below a fixed level, the surplus is kept as liquid reserves, which do not earn interest. When the surplus attains the level, the excess of the surplus over the level will receive interest at a constant rate. If the level goes to infinity, the modified model is reduced to the classical compound Poisson risk model. If the level is set to zero, the modified model becomes the compound Poisson risk model with interest. We study ruin probability and other quantities related to ruin in the modified compound Poisson surplus model by the Gerber–Shiu function and discuss the impact of interest and liquid reserves on the ruin probability, the deficit at ruin, and other ruin quantities. First, we derive a system of integro-differential equations for the Gerber–Shiu function. By solving the system of equations, we obtain the general solution for the Gerber–Shiu function. Then, we give the exact solutions for the Gerber–Shiu function when the initial surplus is equal to the liquid reserve level or equal to zero. These solutions are the key to the exact solution for the Gerber–Shiu function in general cases. As applications, we derive the exact solution for the zero discounted Gerber–Shiu function when claim sizes are exponentially distributed and the exact solution for the ruin probability when claim sizes have Erlang(2) distributions. Finally, we use numerical examples to illustrate the impact of interest and liquid reserves on the ruin probability.

Optimal dividend and issuance of equity policies in the presence of proportional costs

We consider three optimisation problems faced by a company that can control its liquid reserves by paying dividends and by issuing new equity. The first of these problems involves no issuance of new equity and has been considered by several authors in the literature. The second one aims at maximising the expected discounted dividend payments minus the expected discounted costs of issuing new equity over all strategies associated with positive reserves at all times. The third problem has the same objective as the second one, but with no constraints on the reserves. Assuming proportional issuance of equity costs, we derive closed form solutions and we completely characterise the optimal strategies. We also provide a relationship between the three problems.

Markets, Reserves and Lenders of Last Resort as Sources of Bank Liquidity

We study the long standing issue of whether markets can supply banks with sufficient liquidity or whether markets should be complemented with a lender of last resort (LOLR). For this purpose, we develop an extended version of the recent model of Holmstrom and Tirole (1998) on the supply of liquidity to firms. H&Ts original model analyses liquidity supply to firms that are facing solvency shocks. We apply their framework to banking and extend the framework to admit the analysis of problems associated with transitory liquidity outflows, even absent any change in a bank's value. Our premise is that the scope for moral hazard may increase in connection with liquidity outflows. Moral hazard, which we interpret as the possibility of laxity in banks' monitoring of firms, may increase with liquidity outflows because banks need to increase their monitoring efforts in order to safeguard their own interests. The model illustrates many key aspects the classical LOLR debate. The model shows how moral hazard limits of banks' ability to borrow from markets to cover liquidity outflows. It also predicts banks' demand for liquid reserves and the economies associated with centralization of reserves in a liquidity pool when the holding of liquid reserves entails opportunity costs. Finally, the model enables discussion of viable lending policies for the LOLR and contrasts these with the 'Bagehotian principles', which are still widely used as benchmark criteria in evaluating LOLR operations.

Are Branch Banks Better Survivors? Evidence from the Depression
 Era

I. INTRODUCTION In recent years, branch banking has been promoted as a way of increasing the stability of the banking system. The reasoning is straightforward. Branching facilitates geographic diversification. Diversification in turn reduces the risk that a geographically focused idiosyncratic shock will affect a bank severely enough to cause it to fail. This has been noted both historically, by Southworth (1928), and in the recent literature, for example by Gart (1994). The promise of increased stability was one of the reasons for recent legislation (such as the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994) deregulating the banking sector to allow branching. While the creation of branch bank networks has been heralded as a source of stability, the lack of branch banking has often been blamed for the prevalence of banking crises in the United States. Friedman and Schwartz (1963) blamed the high failure rate of U.S. banks during the Depression on the lack of branching. Recent work by Grossman (1995) suggested that countries with extensive branch networks were less likely to experience a banking crisis in the 1930s. Focusing on a more modern crisis, Gart (1994) suggested that interstate branching might have mitigated the large losses of the savings and loan crisis of the 1980s. This article tests the conventional wisdom that allowing banks to establish branches increases their ability to withstand shocks and reduces failures within the banking sector. Specifically I test whether branching increased the length of survival of individual banks in the Great Depression. By using individual banks, I am able to separate the effect of branching from effects of associated characteristics, such as bank size. The first four years of the Depression are used because this is the most recent period in the United States where both unit and branch banks existed, large numbers of banks failed, and the debate over branching features prominently in the literature on this period. The results are striking. Branch banks are found to be less likely to survive and to survive for shorter periods of time. Because these results are so different from those of previous work, additional investigation is undertaken to determine why they are obtained. Branching allows banks to diversify their assets by improving access to different industries that may respond to shocks differently, as in Gart (1994), and by reducing exposure to spatially concentrated shocks, which might be especially important in agricultural regions, as noted by Southworth (1928) and Wheelock (1995). White (1984) argues that branching also allows banks to diversify their liabilities by expanding the pool of depositors, which, as long as depositors who differ by location also differ in their behavior, may reduce deposit volatility. The conventional wisdom in the literature is that banks used this diversification to reduce the level of risk to which they were exposed. As suggested by Hughes et al. (1996), however, this diversification allows banks to reoptimize their portfolios. Banks can either accept a lower level of risk and the same level of profits or they can increase their profits and maintain the same overall risk level by increasing the risk associated with individual loans and reducing the cash reserves used to meet deposits. Although changes in both the risk associated with loan portfolios and the ratio of liquid reserves to deposits likely affected bank performance during the Depression, the explanation developed here focuses on the reserve to deposit ratio. (1) I hypothesize that banks choose the amount of reserves held to meet deposit withdrawals, or the level of liquidity risk. Branch banks have a different risk-return trade-off, because they are able to diversify away idiosyncratic withdrawals and smooth the level of deposits. Because of this different trade-off, branch banks hold fewer reserves and more loans than unit banks. …

Husky Energy Inc.

AbstractOil and Gas (MIC: 14.2 SIC: 1311 NAIC: 211111)Husky Energy is a Canadian integrated energy and energy‐related company with operations in upstream, midstream and refined products. Co.'s upstream business includes the exploration for and development and production of crude oil and sulfur. Co.'s midstream operations include the upgrading of heavy crude oil into synthetic crude oil and the marketing of crude oil, natural gas and petroleum coke. Refined products comprise the refining, marketing and distribution of gasoline, diesel and ancillary services. As of Dec 31 2006, Co. had total net proved crude oil and natural gas liquid reserves of 647 million barrels and total of net proved natural gas reserves of 2,143 billion cubic feet.

Bank runs and investment decisions revisited

We examine how the possibility of a bank run affects the investment decisions made by a competitive bank. Cooper and Ross [1998. Bank runs: liquidity costs and investment distortions. Journal of Monetary Economics 41, 27–38] have shown that when the probability of a run is small, the bank will offer a contract that admits a bank-run equilibrium. We show that, in this case, the bank will chose to hold an amount of liquid reserves exactly equal to what withdrawal demand will be if a run does not occur; precautionary or “excess” liquidity will not be held. This result allows us to show that when the cost of liquidating investment early is high, an increase in the probability of a run will lead the bank to invest less. However, when liquidation costs are moderate, the level of investment is increasing in the probability of a run.

Bank Runs and Investment Decisions Revisited

We examine how the possibility of a bank run affects the deposit contract offered and the investment decisions made by a competitive bank. Cooper and Ross (1998) have shown that when the probability of a run is small, the bank will offer a contract that admits a bank-run equilibrium. We show that, in this case, the bank will chose to hold an amount of liquid reserves exactly equal to what withdrawal demand will be if a run does not occur. In other words, precautionary or excess liquidity will not be held. This result allows us to determine how the possibility of a bank run affects the level of illiquid investment chosen by a bank. We show that when the cost of liquidating investment early is high, the level of investment is decreasing in the probability of a run. However, when liquidation costs are moderate, the level of investment is actually increasing in the probability of a run.

Are Branch Banks Better Survivors? Evidence from the Depression Era

It is widely argued in the literature on the Great Depression that the prevalence of unit banks aggravated the problem of financial instability that afflicted the United States. This article tests the theory that more widespread branch banking would have reduced financial turbulence by examining the survival of individual branch and unit banks. Results indicate that instead of being more likely to survive, branch banks were more likely to fail. Further investigation suggests that this higher failure rate occurred because branch banks systematically held riskier portfolios than unit banks.

Economic analysis of near-natural beech stand management in Northern Germany

Based on an empirical study of the forest practise at Lauenburgische Kreisforsten in Northern Germany an economic analysis of near-natural beech stand management is performed. The profitability, cash flow and economic flexibility of near-natural management (NNM) is compared to that of converting to: (i) Norway spruce, (ii) a clear felling beech regime with a rotation of 120 years (CF) and (iii) a cyclic beech regime with a regeneration thinning at stand age 90 and liquidation of the last holdovers at age 110 (CYC). The internal rate of return (IRR) of NNM is 2.9%, which for many investors would be a satisfactory real rate of return. For required real rates of return less than 2.5%, the net present value (NPV) of NNM exceeds the NPV of clearing the stand and planting Norway spruce at all stages of the rotation as well as the NPV of the two alternative beech regimes. When comparing the profitability of the alternatives using IRR as criteria, both of the alternatives CYC (IRR=3.3%) and Norway spruce (IRR=3.1%) should be preferred above NNM and CF (IRR=1.8%). However, it was discussed that when comparing investment alternatives like those presented in this paper the choice between investment alternatives should be dictated by their NPV at the required rate of return and not their IRR. In comparison to the management alternatives CYC and CF, NNM provides high mean annual net revenue, which exhibits relatively small fluctuations during the rotation. The latter may be important, especially at forest districts which do not have forest stands in the entire range of age classes and therefore may foresee periodical lack of liquidity. Due to the prolonged retention of the holdovers, the accumulation of capital in the forest is greater for NNM than for CYC and CF. Since economic flexibility of a silvicultural regime to a large extent is associated with the ability to accumulate liquid reserves in the forest, NNM may provide the owner with greater economic flexibility than the two shorter-rotation beech alternatives. It is concluded that near-natural beech stand management may provide an economically sound alternative to other, more traditional regimes for investors having a required real rate of return within the range common to most forest investments.

The North Brae and Beinn Fields, Block 16/7a, UK North Sea

Abstract North Brae is located in Block 16/07a, and was discovered in 1975 by Pan Ocean Oil Company. The field was purchased by Marathon Oil Company in 1976 and was delineated in the early 1980s. Production by gas recycling was commenced in 1988. Liquid reserves are estimated at 207 MMBBLs with recoverable dry gas of 800 BCF. The North Brae Field is one of three gas/condensate fields in the Brae fields area of the South Viking Graben in the UK Sector of the North Sea. The reservoir is part of a large turbidite and debris flow, submarine fan system that also encompasses the East Brae and Kingfisher fields to the northeast of North Brae. North Brae is located at the proximal end of this fan system, and channelized massive conglomerates and sandstones characterize its reservoirs. The stratigraphy of the fan system was influenced by highly variable changes in relative sea level that controlled sediment input. Structural activity was also important, such as syn-sedimentary normal faulting related to the subsidence of the South Viking Graben, and structural inversion, in a series of regional compressive episodes commencing in the Late Jurassic and Early Cretaceous.

Reserve Requirements, Bank Runs, and Optimal Policies in Small Open Economies

Abstract: This paper rationalizes as the outcome of an optimal policy decision the pattern of reserve requirements and other macroeconomic variables in the aftermath of a bank run. The paper develops a general equilibrium model that departs from the standard small open economy (SOE) model in three dimensions: (i) capital mobility is not perfect, (ii) there exists a costly banking system, and (iii) there is an externality affecting individual banks' decisions. The results suggest that the path of reserve requirements would depend on the type of shock that the economy receives and the effect that this shock produces on the interest rate. Interestingly, the size of the risk premium will affect the reaction of the economy to the shock. It is also shown that the dynamic adjustment will be slightly different for permanent and temporary shocks, and it will also depend on the access that the economy has to foreign funds. JEL classification: E44, E58, F30, F41, G28 Key words: reserve requirements, optimal policy, financial crisis, emerging markets 1. Introduction Saving for a rainy day is well understood in all economic fields. If regulators want to apply this policy to the amount of liquidity that banks should hold, they will say accumulate liquidity in normal times and use it in bad times, which in principle seems intuitive and reasonable. But, the evidence does not support this conventional wisdom. In fact, it suggests that the policymaker flips a coin when bad times arrive. This paper shows that resorting to the liquidity accumulated during the good days will depend on the underlying shock and the state of the economy at the time of the shock. Also, it shows that the same shock will generate a cloudy day under some circumstances and will not under others. (1) Therefore, the policymaker's reaction could be understood as an optimal response to different situations, instead as of flipping coins. Liquidity provision is key in the management of systemic banking crises, especially in emerging economies, where the lack of systemic liquidity can exacerbate problems. On one hand, without enough support, a liquidity crisis could lead to a solvency crisis and/or a credit crunch in the economy. On the other hand, the overuse of rediscounts or repos to provide liquidity assistance could lead to excessive money printing, and could weaken the peg in a fixed exchange rate regime or generate inflationary pressures. There is evidence that shows that during the 90's several central banks provided systemic liquidity to finance the bank runs generated in the financial crises. (2) In general, the liquidity support includes all the funds provided to the system through rediscounts, repos, contingent contracts, and the reduction of reserve requirements. (3) This last instrument is the focus of the paper. The literature on the optimality of maintaining a stock of liquid reserves is broad (Baltensperger (1974), Santomero (1984), Cothren and Waud (1994), Stein (1995), Agenor et al. (2000)). Also, there are some works that analyze the use of reserve requirements from a macroeconomic standpoint: as a countercyclical tool (Edwards and Vegh (1997), Calvo et al. (1993)), as a mechanism to enforce capital requirements (Fernandez and Guidotti (1996)), or as an instrument that helps to collect the inflation tax (Englud and Svensson (1988)). There are some other papers that study optimal policies under financial crises (Lahiri and Vegh (2003); Rebelo and Vegh (2001), Ganapolsky (2003)). (4) But, in spite of the importance of reserve requirements as a liquidity provider, there is no work that studies its optimal use in a financial crisis. The purpose of this paper is to provide a framework to understand the behavior of reserve requirements as the outcome of an optimal policy decision. In particular, it rationalizes the pattern of reserve requirements and other macroeconomic variables in the aftermath of a bank run. …

Sovereign Debt Contract and Optimal Consumption-Investment Strategies

We present a model in which a sovereign country optimally decides on its consumption and investment policies. In the paper we allow for the sovereign borrower to keep the fraction of his augmented wealth in so-called international reserves. We further assume that these reserves can be deposited at the risk-free rate. In this framework we obtain analytical solutions for optimal consumption and investment rules, as well as formulas for optimal default boundary and the value of the risky loan. In the paper we assume that in the case of default the lender can impose economic and political sanctions against the borrower and also can seize an implicit collateral. However, it is shown that only sanctions are necessary for the existence of positive lending equilibrium. We also show that when the country is getting very close to its default wealth level, then its relative risk aversion decreases and the country increases its consumption rate and the risky investment fraction at the expense of available liquid reserves.

Sovereign Debt Contract and Optimal Consumption-Investment Strategies

We present a model in which a sovereign country optimally decides on its consumption and investment policies as well as on the optimal time to default. In the paper we allow the sovereign borrower to keep the fraction of its augmented wealth in so-called international reserves. We further assume that these reserves can be deposited at the risk-free rate. In this framework, we obtain analytical solutions for optimal consumption and investment rules, as well as formulas for optimal default boundary and the value of the risky loan. In the paper we assume that in the case of default the lender can impose economic and political sanctions against the borrower and also can seize an implicit collateral. We show that when the country is getting very close to its default wealth level, then its relative risk aversion decreases and the country increases its consumption rate and the risky investment fraction at the expense of available liquid reserves.

Belgian Intragroup Relations and the Determinants of Corporate Liquid Reserves

The determinants of liquid reserves are investigated for a sample of 1038 large Belgian non‐financial firms in the 1992–94 period. The results confirm the hypothesis that the terms of payment of intragroup claims can be adjusted to the firm’s liquidity needs, thereby reducing the need for liquid reserves. Furthermore, the results confirm the transaction motive for holding liquid reserves, but only partially confirm the precautionary motive. Finally, the results indicate that liquid reserves play a significant role in the financing of new investments, as predicted by the pecking order model of Myers and Majluf (1984).