Liquidity Management: A Self Study Guide · Liquidity Management: Extended course Lesson 6 GTZ 3 Other Dimensions of Vault Cash Management We should note that, in practice, vault

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Liquidity Management: A Self Study Guide Extended course

Lesson 6:

Vault Cash Planning Learning Objectives

When you have studied this lesson you should be able to: • explain why vault cash is of special importance to micro-finance organizations, • describe how some MFIs avoid dealing with vault cash entirely, • specify the costs of vault cash and explain the trade-off between holding costs and

shipment costs, • develop plausible rules of thumb for setting upper and lower vault cash limits, • use the Miller-Orr model to derive vault cash parameters for minimizing costs, • calculate the total operating vault cash change per period in a dynamic approach to

vault cash planning, • derive a forward-looking plan for vault cash shipments based on forecasted demand. Pre-Test (Solutions are at the end of the lesson)

P1 Which of the following are costs of holding vault cash?

a) insurance b) counting and checking for counterfeits c) cost of armored transport d) loss from theft e) minimum reserve required by the central bank

Choose: A) all of the above B) a), b), c) and e) C) a), b), c) and d)

P2 What is the most expensive form of holding liquidity?

D) vault cash E) demand deposits with other banks F) liquid investments

P3 If the fixed cost per cash shipment increases it would be rational to hold

A) less vault cash B) more vault cash C) the same amount of vault cash

Liquidity Management: Extended course Lesson 6

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P4 If the insurance premium for vault cash increases from 1% to 2% of the average vault cash balance per month it would be rational to

A) make more frequent cash shipments B) reduce the number of cash shipments C) not change the planned number of cash shipments

6.1 The Basic Issues of Vault Cash Management For a commercial bank in a developed economy, physical cash plays a very small role today. Individual and corporate customers access their accounts primarily via check or payment order and also replenish their accounts mostly by wire transfer, payroll deposit or other instruments that do not require the physical movement of currency bills and coins. Vault cash management therefore has been a rather neglected topic in commercial banking. Only recently has vault cash been rediscovered by commercial banks, as they are searching for new areas to further cut the costs involved in the remaining cash transactions in order to stay competitive1. Importance of Vault Cash in MFIs In the micro-finance world, however, vault cash is a much more important part of liquidity management than is the case in established commercial banks. Since the majority of MFIs do not act as payment agents for their customers, loan disbursements and repayments as well as deposit transactions are largely executed in physical currency. This means that most uses of liquidity and most contributions to liquidity pass through the vault. Let's imagine a one-unit, village bank that has no links with the formal financial sector, not even an account with a local bank or another MFI. The bank’s founders bring in their equity in cash bills. The clients deposit savings in cash and also take out and repay loans in physical money. Likewise, all operating expenses are paid in currency. Only in this extreme example, can we say that vault cash management is indeed equivalent to liquidity management. In reality, however, the smallest and simplest MFI operations sometimes need no vault cash management at all, but conduct business without ever touching physical cash. This is a practical option for MFIs that do not deal in retail deposits and operate in urban areas, where they can use accounts with commercial banks to disburse loans and receive payments. For those MFIs that have to hold some vault cash because of their remote location or the service expectations of their customers, the main question becomes: How much of our liquidity should we hold in bank deposits or other liquid assets and how much should we keep in the vault?

1 Some U.S. banks are now beginning to employ vault cash management software based on artificial intelligence concepts and neural networks that can learn from their own decisions and improve predictions over time.


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Other Dimensions of Vault Cash Management

We should note that, in practice, vault cash management has more dimensions than just the question of how much cash to hold. One also has to keep track of the denominations of the bills and coins. Moreover, many banks like to return "used" cash to a head office vault or even the central bank, where the money is checked for counterfeits, worn bills are sorted out and everything is neatly repackaged into standard lots. For the purposes of this manual, however, we will assume that the cash stock is in small enough denominations to satisfy all payment needs and that the MFI will reuse the cash it receives from customers. How Much to Keep in the Vault?

How much then should we keep in the vault? One may actually consider holding the entire liquidity as vault cash thereby minimizing the risk of ever running out of currency. Obviously, this cannot work unless the MFI fits the example of extreme cash reliance described above. Normally, a MFI will have to maintain some liquidity in its accounts with other banks in order to clear checks and cover payment orders. All of the MFI's investing and financing activities, as well as many of the operating expenses, will also be transacted in book-money. Since the current accounts with other formal banks are the MFI's connection to the world financial system, a certain part of the liquidity must be held there. The Cost of Vault Cash

When deciding the proportions of book balances versus physical cash holdings, we also have to consider that the vault is an expensive place to hold liquidity. Not only do we lose the interest otherwise earned on account balances. We are also exposed to the risk of theft or must be covered by costly insurance. Moreover, vault cash has storage and handling costs (regular counting under four eyes etc.) and is limited by the physical size of the vault. In consequence, most banks actually lean towards holding as little as possible of their liquidity in vault cash while still avoiding stock-outs. Size of Vault Reserve versus Shipment Frequency

Holding a large vault reserve is not the only way to prevent a shortfall of vault cash, however. One can achieve the same level of safety by ensuring that cash shipments can be brought in quickly and frequently. This could be as simple as sending an employee across the street to the branch of a formal bank to cash a check drawn on the MFI's account. All cash shipments, even through such informal solutions, cost money. This cost is usually a fixed amount per transaction, independent of the size of the transport. Such shipment

Box 6.1: Alexandria Business Association, Egypt

Alexandria Business Association (ABA) is a mid-size, micro-lending institution that was set up in 1989 with the help of USAID. ABA uses the branches of an established commercial bank to disburse loans and collect payments. When paying out a loan, ABA simply writes a check against its account with the commercial bank. Customers can cash the check at one of the 28 commercial bank branches in the area. Borrowers make their payments in cash at any of the branches. The cash deposits are credited to the ABA account at the commercial bank.

Source: Tom Dichter, Egypt – Alexandria Business Association – ABA, Case Studies in Microfinance, World Bank, 1997.


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costs might include: the employee's time, that of the accompanying security guard, fuel and maintenance for the vehicle used, the time spent on counting the money and completing the documentation for the shipment etc. Obviously, the fixed cost of a cash shipment increases with the distance to the bank where the cash is ordered. Again, vault cash management is a trade-off between conflicting goals, very similar to what we encountered when first discussing overall liquidity management. Due to the substantial holding costs, one would like to reduce vault cash to a minimum. In order to meet all payment requests with reduced vault cash holdings, we would have to bring in cash and ship away cash more frequently. The problem with cash shipments is that their costs are largely fixed, regardless of the amount of currency transported. Therefore, it would be more efficient to make fewer larger shipments rather than many small ones. Fewer, larger shipments, however, will increase the average cash balance in the vault, leading to higher holding costs. The Determinants of Optimal Vault Cash

The above clearly points to two of the most important factors in determining how much vault cash a bank should hold:

1. fixed shipment costs 2. vault cash holding costs

The third factor to consider is some measure of cash demand. Later in this lesson, we will combine all three factors in an explicit model that derives optimal vault cash levels with mathematical methods (see chapter 6.3: Miller-Orr Control Limit Model). Before we introduce the formal model, we will describe some simple practical alternatives that might also lead to satisfactory vault cash management. Comprehension Check

(Please refer to the text to find the answers) i. How do some micro-lending institutions manage to avoid holding vault cash entirely? ii. Why is it not practical to hold the entire required liquidity in the vault? iii. Which additional factors besides the simple amount of vault cash should be considered

when designing a vault cash system in practice? iv. What are the cost factors of vault cash? v. Name the three determinants of an optimal vault cash level.


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6.2 Basic Operating Rules for Vault Cash Vault Cash Reserve Ratio

When considering the amount of vault cash to hold, one will quickly come across different vault cash reserve ratios. In its simplest form, such a ratio could be defined as follows:

Vault cashVault Cash Reserve Ratio =

Total deposits

Since possible deposit withdrawals are an important source of the uncertainty about future vault cash needs, one may want to hold a certain minimum percentage of vault cash against total deposits at all times. Examples of Reserve Rules

Bank Rakyat Indonesia, for example, uses an upper limit for its vault cash holdings of 4% of deposits and a fixed lower limit. In 1995 all U.S. banks held an average of about 7% vault cash compared to transaction and demand deposits. The PEARLS system of performance indicators for credit unions recommends a 10% vault cash ratio against withdrawable deposits. From these examples, one would be tempted to speculate as to what might be a good ratio for one's own operation. Unfortunately, there is no a-priori basis for choosing a high or a low ratio. The vault cash reserve ratio can be a useful measure for comparing average vault cash levels between different institutions in a retrospective manner. By itself, however, it is not a sufficient tool for determining vault cash levels in a forward-looking plan. Let's think this through: You would choose the vault cash reserve ratio, because you assume that the main need for vault cash comes from depositors suddenly wanting to withdraw their funds. This means that when deposits are declining, you would plan to have more cash in the vault to be prepared. Yet, with the reserve ratio as your primary planning tool, a deposit decline would prompt you to hold less vault cash during a period where the cash outflows are larger than normal. This is not prudent cash planning. Reserve Ratio Combined with Cash Flow Forecasts

A better way to approach the vault cash problem would be to develop an estimate of the cash flows during a specified period and then hold enough vault cash to cover the expected outflows. After the deposit outflow has been covered, there is indeed less potential for further vault cash outflows, simply because the deposit base is less. So, the vault cash reserve ratio might be useful in determining the new minimum vault cash holding after the outflow occurred. The difficult part about this latter approach is the development of estimates for the vault cash flows. We will get back to this in section 6.4: Vault Cash Management Based on Specific Cash Flow Projections. Passive Vault Cash Approach

For now, let's assume our MFI has gone through a general cash flow planning process as described in lesson 4 and is confident that it can meet all payment demands over the next 12 months. The only remaining question is the form in which the transactions will materialize. Is a particular cash inflow going to occur at the counter in physical cash or will the person submit a check? Will operating costs be paid in cash or by payment order? One reasonable approach to this problem is to simply wait and see what happens.

Dynamic-Vault-Cash


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Under this passive approach, the MFI holds only a small safety stock of vault cash and keeps the majority of the liquidity in demand deposits with banks or in highly liquid investments. If the actual vault cash level falls below a certain minimum limit, a cash delivery is ordered in. If it reaches a certain maximum limit, cash is shipped away and credited to the MFI's bank account. Since cash shipments have fixed costs, the MFI would not allow very small shipments, but require an efficient shipment batch that falls between certain lower and upper limits. At this point, one could use statistical theory to compute optimal values for the lower and the upper cash limit and for the shipment size. This is essentially what the Miller-Orr model in section 6.3 does. Alternatively, one could use some rules of thumb to establish the same types of vault cash parameters. Simple Operating Rules

There are many ways to come up with such simple operating rules. Some may work for a specific MFI but may not deliver satisfactory results for others. The only way to decide between alternative methods is to test them against the specific situation in which a MFI operates. Example of a Rule of Thumb System

Let's look at one of the many possible approaches to establishing vault cash limits. Assume it takes three days to order cash and have it delivered. We could look back and take the biggest daily net cash outflow recorded over the last year and multiply this amount times three days plus one day safety margin. If we kept this amount of cash in our vault at all times, then we could cover four days of maximum cash outflows in a row before running out. Of course, we would order a delivery of cash on the first day that we fell below this minimum. The shipment would arrive in three days, well before we would run out of cash.

Lower vault cash limit = (Days in shipping cycle + days safety margin) x maximum net daily cash outflow

In addition to the 4th day of cash stock, we might want to consider an adjustment for overall business growth, which would lead to a gradual increase in the lower cash limit. Such an adjustment is particularly important in a country with high inflation, where the size of cash transactions and the minimum balance grow constantly, simply because the money is worth less and less. It may turn out that such a lower limit is far too high because the MFI rarely sees two extreme withdrawal days in a row, let alone four. In such a case, one could gradually start reducing the lower limits and slowly work towards an appropriate minimum. Order Size

The next consideration is: how much cash the MFI should order once it hits the lower vault cash limit. This may already be determined simply by the fact that the commercial bank where the MFI orders the cash, will only send out a bank courier for a certain minimum. There is probably also an absolute maximum the courier, using a regular vehicle, may carry in a briefcase. If the MFI is serviced by an armored truck route, however, a full truck load is probably far beyond a reasonable size for a MFI. Since we based our lower cash limit on a scenario of four maximum net withdrawal days in a row, should we also order that amount of cash if we fall below the limit? Assume that we had only the minimum cash limit in the vault when we experienced the very unlikely scenario of five maximum net withdrawal days in a row. If we knew on the first day of


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withdrawals that we were in a five day downward trend, we could order one big cash shipment that ensured we still had our minimum vault cash at the end of day five. Since it is much more likely, however, that the withdrawal trend will reverse after a day or two, it is more efficient to order a day’s worth of withdrawals on day one, and then order a second shipment of the same size the next day, if the withdrawal trend continues (see figure 6.1 below). Example of an Order Size Rule

So, one possible rule of thumb would be to make the standard size of a cash shipment equal to the largest net daily vault cash withdrawal over the last year (adjusted for business growth and inflation). This would allow the MFI to passively follow the actual vault cash trend in small increments. In addition, it would avoid a situation in which several shipment orders were triggered on the same day. A look at figure 6.1 makes this clear. A cash shipment order is initiated as soon as the vault cash balance plus incoming shipments in transit falls below the minimum vault cash limit. If the shipment size was only P50,000 on a day that the MFI experiences the maximum of P100,000 net withdrawals, there would be one shipment request early in the morning and a second order later in the day, when the withdrawals first exceed P50,000. While a standard batch as large as the maximum daily net cash outflow safeguards against more than one delivery order per day, it might bring the cash balance so close to the upper cash limit that we will soon be shipping money away again. One should therefore make sure that the standard batch size is in reasonable proportion to the upper cash limit; say less than half the distance between the lower and the upper limit. This would lead to the following rule for determining the standard incoming order batch:

Standard incoming batch = MIN

Figure 6.1 Example of a Passive Vault Cash Ordering System

End of Day 0 1 2 3 4 5 6 7

Net vault cash flow -100 -100 -100 -100 -100 0 +50

Actual end of day vault cash 400 300 200 200 200 200 300 450

Shipments triggered 100 100 100 100 100 0 0

Shipments in transit 100 200 200 200 200 100 0

Effect of shipments 100 100 100 100 100

Actual end of day vault cash + shipments in transit

400 400 400 400 400 400 400 450

Assumptions:

• Lower Order Limit: 400 • Standard Order Size: 100 • Maximum Daily Net Cash Outflow: 100

Max. daily net cash outflow ;

Upper cash limit – Lower cash limit 2


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Upper Vault Cash Limit

Next, we need to determine a reasonable rule for the upper vault cash limit. Once the upper cash limit is reached, the MFI would automatically start shipping cash away in certain standard batches. It seems logical that the upper limit is defined as a function of the lower cash limit, the maximum daily net inflow of cash and the length of the shipment cycle from order to delivery. Most MFIs will want to avoid a situation in which there are simultaneous pending orders for incoming and outgoing shipments. In other words, it does not make sense for an armored car taking cash away from the MFI to pass another armored car on the highway that is bringing cash to the MFI. If the upper limit is too close to the lower limit, the cash balance could easily dip below the minimum point in the morning, triggering an incoming shipment and then rise above the upper limit in the afternoon, releasing an order for an outgoing delivery. Example of an Upper Limit Rule

Imagine the cash level briefly touches the lower trigger point and that there are only net inflows of cash after that. If it takes three days for the shipment to arrive and we want to avoid couriers crossing paths then, even with maximum cash inflows, we should not reach the upper limit before the incoming shipment has arrived. This argument leads to the following rule of thumb for the upper vault cash limit:

Upper vault cash limit = (Lower limit + Days in shipping cycle) x maximum net daily cash inflow

Obviously, one would need to make sure that this upper limit is allowable in terms of cash insurance limits and the actual storage capacity in the vault. Standard Outgoing Batch Size

The last parameter that we still need to define in this rule-of-thumb vault cash system is the standard size of the outgoing cash shipment. Again, our objective is to keep the shipment small enough so that we do not catapult the cash level below the lower limit just a day or two after we shipped money off. At the same time, the shipment should be big enough so that we avoid triggering more than one shipment per day. So, let's say we make the outgoing standard shipment equal to the maximum net cash inflow per day. This would assure that there was at most one shipment per day. If this still keeps us above the mid-point between upper and lower cash limits, there will be little risk of triggering an incoming shipment shortly after the outgoing dispatch.

Standard outgoing batch = MIN

Max. daily net cash inflow ;

Upper cash limit – Lower cash limit 2


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Comprehension Check

(Please refer to the text to find the answers) i. How can the vault cash reserve ratio be used in a forward-looking cash plan? ii. How can one justify a passive approach to vault cash planning? iii. What are the basic parameters of a passive vault cash system? iv. Give an example of a rule of thumb for determining the lower vault cash limit. v. Why must standard shipment sizes take into account the upper and lower cash limits? vi. What happens when the MFI reaches the upper vault cash limit? vii. Give an example of a rule of thumb for determining the upper vault cash limit. viii. Give one argument in favor of large standard outgoing shipments and one in favor of

small outgoing shipments.


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6.3 The Miller-Orr Control Limit Model The Miller-Orr model is based on the same passive vault cash management scenario as described above. Instead of formulating rules of thumb about the lower and upper cash limits and efficient order sizes, this model derives an optimal solution that will minimize the total cost of vault cash. The Miller-Orr model assumes that the daily movements of the vault cash balance are the consequence of many individual actions that to the bank appear random. On any given day, the cash balance either goes up or down, independent of the prior day's change. In probability theory, this situation is known as a random walk. The model uses the statistical properties of the random walk and combines these with the cost functions of transportation expenses and holding costs. On the basis of these assumptions, one can calculate an upper and a lower cash limit as well as an optimal return point. Derivation of the Optimal Cash Parameters

The optimal values in the Miller-Orr model are usually calculated for a lower cash limit of zero. A positive lower limit can subsequently be incorporated into the results by simply shifting the model parameters up in parallel. The optimal return cash level is given by:

1 3

3 × Order cost × Variance of daily vault balance

4 × Daily holding cost of vault cash

The upper control limit is three times the optimal return cash level:

Upper Control Limit = 3 × Optimal return cash level

We will skip the mathematical justification for the optimal results according to the Miller-Orr model. It is easy to see, however, that the inputs into the formula are consistent with our intuitive argumentation about the important factors influencing vault cash levels in the "passive" approach. The formula explicitly takes account of the holding costs of vault cash and the fixed costs per shipment order. The cash demand is represented by the variance of daily changes in the cash position. Calculation of the Variance Input

The variance is calculated as the mean of the quadratic deviations from the average:

n2

ii 1

1(x x)

n ====

−−−−∑∑∑∑

where n is equal to the number of days sampled, xi is the vault cash balance of day i, and x is equal to the average daily balance over all periods under consideration. The variance is a measure of the erraticism of vault cash demand. A larger variance leads to a higher return cash level, a higher upper control limit and thus to larger cash shipment batches.


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Using the Miller-Orr Model

Figure 6.2 illustrates the use of the Miller-Orr model. The cash manager only takes action when the cash balance pierces either the upper or the lower control limit. When this happens, the difference between the actual cash balance and the optimal return cash level is the amount of cash either transferred to or transferred from the MFI.

Figure 6.2: Miller-Orr Control Limit Model

Cash shippedout

Cash shippedin

Upperlimit

Lowerlimit

Optimalreturn

point

Most likely, the bank will specify a minimum balance larger than zero. This minimum becomes the lower limit just as in figure 6.2. The upper control limit and the optimal return cash level then simply move up in parallel by the amount of the lower limit. Let's walk through the Miller-Orr model with a simple example. The vault manager estimates the fixed ordering costs at $100 per transaction, the total annual holding cost of cash is 30% and the variance of daily cash balances is $35,000. For now, we hold the minimum cash reserve at zero and then calculate the optimal return cash level and the upper control limit as follows:

1 3

3 $100 $35,000Optimal return level = $1, 473

4 0.30 365

× ×=

×

Upper control limit = 3 $1,473 = $ 4,419×

If the vault manager wants to maintain an "iron" reserve of $1,000 at all times, the revised vault cash parameters become:

= $1,000Lower Control Limit

= $2,473Optimal Return Level

= $5,419Upper Control Limit

Miller-Orr-Vault


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Comprehension Check

(Please refer to the text to find the answers) i. What is the basic assumption about the daily net changes in the vault cash balance

underlying the Miller-Orr model? ii. How can the Miller-Orr model be adjusted to reflect a lower vault limit larger than

zero? iii. How much cash is ordered when the vault balance reaches the lower vault cash limit? iv. How does the Miller-Orr model take into account the expected increased vault cash

requirements due to the planned launch of a new loan product?

6.4 Vault Cash Management Based on Specific Cash Flow

Projections So far, our approach to vault cash management has been characterized by the assumption that the daily inflows and outflows of vault cash are random. This is not unrealistic given the many unknown factors that influence the amount and timing of vault cash demands. However, there should be a way to include some of the knowledge about the expected trend and seasonal factors that helped us develop the general cash flow forecast. Let's look at the 12-month cash flow forecast in figure 4.13 again. We could go through each line item and estimate the proportion of the cash flows that are transacted in physical currency. If we then reduce the cash flow table to just the physical cash flows, we could calculate the periodic vault cash change as well as the cumulative vault cash balance. Just as we did before, we can compare this operating or "exogenous" vault cash

Dynamic-Vault-Cash


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balance with our pre-determined minimum vault reserve. We can then take explicit management actions, i.e. order a cash delivery or ship away excess cash. The real advantage of this prior knowledge about vault cash movements is that we can now anticipate a cash need and plan our cash shipments in a pro-active way, instead of just waiting until we hit the lower control limit. This means, for example, that the target cash level at the end of period one is given by the required minimum plus the expected net outflow in period two. Example

Let's work through this process with the numbers from our previous example and use a similar table to summarize only the vault transactions (see figure 6.3). We assume that all cash flows from financial activities occur in vault cash, except for the interest on long-term debt, which will almost certainly be remitted via our account with a formal financial institution. The distinctions for operating expenses are more subtle. Salaries can safely be assumed to leave the MFI in vault cash. Even if the salary is actually credited to the employee's own account with the MFI in a first step, we can still expect entire net wages to be taken out in vault cash shortly after payday. Benefits such as social security contributions or employer taxes, however, will in all likelihood be transferred by the MFI via payment order, not in physical cash. In this example, we assume that the total payroll expense consists of 70% cash wages and 30% non-cash benefits. From past experience, we might know that 50% of administrative expenses and other operating expenses have to be paid in vault cash. Occupancy expenses, however, are paid entirely on a non-cash basis. The proceeds from a share capital increase are received in the form of a credit to the MFI account without a vault cash consequence. Dividends, taxes and the invoice for computer equipment are paid via payment order. We assume that only one third of the branch improvements are paid for in vault cash and the rest is paid via check. With these final assumptions, we can now calculate the expected vault cash changes over the next 12 months (figure 6.3) and then plan our vault shipments based on the expected vault cash flows (figure 6.4). The vault cash system depicted in figure 6.4 uses a minimum vault cash reserve of P20,000 that should be observed at all times. The target balance at the end of period one is equal to the minimum reserve plus the expected outflow during period two. If a net inflow is expected for period two, the target balance at the end of the previous period is simply equal to the minimum reserve.

Target Balance in it

i+1

i+1

= Minimum reserve + expected vault cash outflow in t ,if cash change in t is negative

= Minimum reserve otherwise.

The shipment order triggered in a particular period is equal to the target balance for the end of the same period minus the final vault balance before shipments.

Shipment in it

i i= Target balance in t -Final vault balance in t before shipments.


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Figure 6.3: Total "Operating" Vault Cash Change before Shipments (Pesos, thousands)

Jan Feb Mar April May June July Aug Sep Oct Nov Dec Total

Financial Activities ∆ Deposits -8.00 56.00 56.00 40.00 -88.00 -72.00 -40.00 40.00 40.00 72.00 56.00 -56.00 96.00 ∆ Loans -28.00 42.00 14.00 0.00 -56.00 -84.00 -98.00 14.00 28.00 42.00 0.00 -42.00 -168.00 Loan interest 18.20 18.60 18.00 17.80 17.80 18.60 19.70 20.90 20.70 20.40 19.80 19.80 230.30 Loan fees / charges 6.30 6.10 6.00 6.00 6.30 6.70 7.10 7.00 6.90 6.70 6.70 6.90 78.70 Deposit interest -4.00 -3.90 -4.10 -4.20 -4.30 -4.10 -3.90 -3.80 -3.90 -4.00 -4.20 -4.30 -48.70 Interest on long-term debt

0.00

Cash loan loss -4.80 -4.60 -4.60 -4.60 -4.80 -5.00 -5.40 -5.30 -5.20 -5.10 -5.10 -5.20 -59.70 ∆ Vault cash from financial activities

-20.30 114.20 85.30 55.00 -129.00 -139.80 -120.50 72.80 86.50 132.00 73.20 -80.80 128.60

Operating Expenses Salaries & benefits -7.00 -7.00 -7.84 -7.84 -7.84 -8.72 -8.72 -8.72 -8.72 -8.72 -8.72 -8.72 -98.56 Administration expenses

-0.84 -0.85 -0.86 -0.86 -0.87 -1.13 -1.14 -1.14 -1.15 -1.16 -1.17 -1.18 -12.35

Occupancy expenses 0.00 Other oper. exp. -0.21 -0.21 -0.22 -0.22 -0.22 -0.22 -0.22 -0.22 -0.23 -0.23 -0.23 -0.23 -2.66 ∆ Vault cash from operating expenses

-8.05 -8.06 -8.92 -8.92 -8.93 -10.07 -10.08 -10.08 -10.10 -10.11 -10.12 -10.13 -113.57

Long-term Inv./Fin. Share capital increase 0.00 Dividends 0.00 Tax payment 0.00 Computer purchase 0.00 New branch, tenant improvements

-5.00 -5.00

Donor loan 0.00 ∆ Vault cash long-term inv. & fin. 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -5.00 0.00 -5.00

Total ∆ Vault Cash -28.35 106.14 76.38 46.08 -137.93 -149.87 -130.58 62.72 76.40 121.89 58.08 -90.93 10.03 Total Cumulative ∆ Vault Cash

-28.35 77.79 154.17 200.25 62.32 -87.55 -218.13 -155.41 -79.01 42.88 100.96 10.03


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Figure 6.4 Planning Vault Cash (Pesos, thousands)

End of

Month

∆ Vault Cash

Ending Vault Cash Before Shipments

Target, End of Month

Order

Dec. 48.35 48.35

Jan. -28.35 20.00 20.00 0.00

Feb. 106.14 126.14 20.00 -106.14

March 76.38 96.38 20.00 -76.38

April 46.08 66.08 157.93 91.85

May -137.93 20.00 169.87 149.87

June -149.87 20.00 150.58 130.58

July -130.58 20.00 20.00 0.00

Aug. 62.72 82.72 20.00 -62.72

Sept. 76.40 96.40 20.00 -76.40

Oct. 121.89 141.89 20.00 -121.89

Nov. 58.08 78.08 110.93 32.85

Dec. -90.93 20.00 50.00 30.00

How to Interpret Figure 6.4

Let's look at the month of April in Figure 6.4, for example. We start the month with P20,000 in the vault, because we expect a net inflow of P46,080 over the course of April. Without any cash shipments in April we would reach a final balance of P66,080. In May, we predict a large outflow of P137,930. The target balance at the end of April, therefore, is P20,000 + P137,930 = P157,930. In order to reach this target balance, we have to order in cash shipments of P91,850. Comprehension Check

(Please refer to the text to find the answers) i. What is the advantage of cash-flow-based vault management compared to a passive

parameter-based vault system? ii. Define the targeted vault cash balance in a cash flow-based, vault planning system. iii. How is the shipment size determined in a cash flow-based vault system? iv. Explain each of the entries in the May 1998 row of Figure 6.4.


GTZ 16

Exercises

(Solutions are at the end of the lesson) E1 The Cost of Vault Cash Assume that ordinary demand balances with your main correspondent bank earn 0.01% interest per day (compounded daily). The vault cash insurance premium is 1% of your average daily vault balance per month, payable every month, based on the cash balances of the previous month. From experience, you estimate that other handling and storage costs of vault cash amount to about 15% of the value per year. What is the total cost of holding P50,000 in the vault for 15 days? What is the total daily holding cost expressed as a percentage of the balance (use linear pro-ration)? E2 Passive Vault Cash Management - Rules of Thumb Your MFI has decided to adopt a passive vault cash approach and you want to test the vault cash parameters proposed in chapter 6.2. Draw up a vault cash plan using the format of figure 6.1 for a 15 day time horizon. Your accounting department tells you that the largest net outflow your institution has experienced over the last year was P50,000. The largest daily cash inflow on record is P30,000. Cash shipments to and from the MFI's commercial correspondent bank take four days from order to receipt. Pick-up of outgoing shipments at the MFI is the day after the order is triggered. When calculating the minimum vault cash level, you decide to apply one extra day of safety margin. Use the following daily net vault cash flow from the past three weeks to see how the proposed vault cash parameters would have worked out for your institution. The starting vault cash balance is P350,000.

Business Day

Net Vault Cash Flow

Business Day

Net Vault Cash Flow

1 -30,000 9 +15,000

2 -35,000 10 -10,000

3 -45,000 11 +35,000

4 +15,000 12 +20,000

5 -35,000 13 +15,000

6 -30,000 14 +25,000

7 -10,000 15 -10,000

8 +25,000


GTZ 17

E3 Passive Vault Cash Management - Rules of Thumb Use the same data as in E2 but assume that your MFI is serviced by a scheduled armored car route once a week. Orders can only be placed every Tuesday (days 2,7,12) for pick-up or delivery two days later. Test the same vault cash parameters as derived in E2 under the new delivery schedule. What kind of adjustment to the vault cash parameters would you recommend based on this 15-day test? E4 Miller-Orr Model Calculate the optimal return level and the lower and upper control limits according to the Miller-Orr model under the following assumptions. Ordinary demand account balances earn 0.3% interest per month (interest payments are registered monthly). The vault cash insurance premium is 0.5% of your average daily vault balance per month. Other handling and storage cost of vault cash amount to about 17% of the value per year. The iron reserve of vault cash is P15,000 and the variance of the daily cash balance is P120,000. Each cash shipment causes fixed costs of P1,000. E5 Dynamic Vault Cash Planning Use People Bank's total "operating" cash change for 1998 from exercise E6 of lesson 4. Refer to the solutions section if you are unsure about your own results. Extract the total vault cash change before shipments for each month in 1998 similarly to figure 6.4. Base your calculations on the following assumptions: All cash flows from financial activities, except interest on long-term debt, will be transacted in physical currency. 30% of non-interest revenue is collected in vault cash. Salaries and Benefits are paid 70% in vault cash and 30% via payment order. 40% of other operating expenses are incurred via the vault. All cash flows from long-term investing and financing occur via the MFI's bank accounts except for the sale of real estate, where 10% of the purchase price is received as a down-payment in physical cash. The remaining 90% is collected a few days later via check. E6 Dynamic Vault Cash Planning Use a table similar to the one in figure 6.4 to plan vault cash at PeopleBank on a monthly basis for 1998. The vault cash balance at the end of December 1997 is $148,781. The desired minimum level of vault cash is $150,000

Miller-Orr-Vault

Dynamic-

Vault-Cash

Dynamic-

Vault-Cash


GTZ 18

Multiple Choice Test

(Solutions are at the end of the lesson) M1 Which additional factors besides the simple amount of vault cash should be

considered when designing a vault cash system?

a) the denomination of the bills and coins b) the physical condition of the vault cash c) regular repackaging and checking for counterfeits

Choose: A) all of the above � B) a) and c) � C) a) and b) �

M2 Which of the following are costs of holding vault cash?

a) insurance b) counting and checking for counterfeits c) cost of armored transport d) loss from theft e) minimum reserve required by the central bank

Choose: A) all of the above � B) a), b), c) and e) � C) a), b), c) and d) �

M3 What are the determinants of an optimal vault cash level?

a) fixed shipment costs b) vault cash holding costs c) demand for vault cash d) number of bank tellers

Choose: A) all of the above � B) a), b) and d) � C) a), b) and c) �


GTZ 19

M4 Which one is not a basic parameter of a passive vault cash system?

A) lower vault cash limit � B) standard incoming shipment size � C) standard outgoing shipment size � D) preferred bill denomination mix � E) upper vault cash limit �

M5 What is the basic assumption about the daily net changes in the vault cash balance

underlying the Miller-Orr model?

A) The daily net change is determined by random chance. �

B) The change in period ti depends on the change in ti-1. �

C) The daily net change captures the expected vault cash outflows in the next few periods.

�

M6 How does the Miller-Orr model take into account expected vault cash requirements

due to the planned launch of a new loan product?

A) The upper control limit increases as a result of

the expected cash requirements.

� B) The model does not take account of expected

future developments.

� C) The lower control limit increases as a result of

the forecast.

� M7 In a dynamic approach to vault cash management, what is the target balance of vault

cash in period ti?

a) "Iron" reserve + expected vault cash outflow in ti+1, if any b) "Iron" reserve if vault cash change in ti+1 is positive c) 3 x optimal return cash level in period ti+1

Choose: A) a) and c) � B) c) � C) a) and b) � D) a), b) and c) combined �


GTZ 20

Solutions to Pre-Test

P1 C) P3 B)

P2 D) P4 A)

Solutions to Multiple Choice

M1 A) M5 A)

M2 C) M6 B)

M3 C) M7 C)

M4 D)

Solutions to Exercises

E1 The Cost of Vault Cash

Lost interest (Opportunity costs): P75.05

Insurance: P250.00

Other handling and storage costs: P312.50

Total: P637.55

Total daily cost is 0.085% (P637.55 : P50,000 / 15).

E2 Passive Vault Cash Management - Rules of Thumb

Lower limit: 5 x P50,000 = P250,000

Upper limit: P250,000+ 4 x P30,000 = P370,000

Standard incoming shipment: P50,000

Standard outgoing shipment: P30,000


GTZ 21

E2 Passive Vault Cash Management, 15 Day Test (Pesos, thousands)

Day 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Net vault flow -30 -35 -45 +15 -35 -30 -10 +25 +15 -10 +35 +20 +15 +25 -10

Actual end of day 350 320 285 240 255 220 240 230 255 320 310 345 365 380 375 335

Shipments triggered +50 +50 -30 -30

Shipments pending +50 +50 +50 +50 +50 +50 -30 -30

Effect of shipments +50 +50 -30 -30

Actual end of day +Shipments pending

320 285 290 305 270 290 280 305 320 310 345 365 350 345 335

E3 Passive Vault Cash Management, Fixed Weekly Armored Car Route, 15 Day Test (Pesos, thousands)

Day 0 1 2 Order Day

3 4 Delivery

5 6 7 Order Day

8 9 Delivery

10 11 12 Order Day

13 14 Delivery

15

Net vault flow -30 -35 -45 +15 -35 -30 -10 +25 +15 -10 +35 +20 +15 +25 -10

Actual end of day 350 320 285 240 255 220 195 185 210 275 265 300 320 335 360 350

Shipments triggered +50

Shipments pending +50 +50

Effect of shipments +50

Actual end of day +Shipments pending

320 285 240 255 220 195 235 260 275 265 300 320 335 360 350


GTZ 22

E4 Miller-Orr Model

Total holding cost of vault cash: 26.7%

Lower control limit = P15,000

Optimal return level = P15,000 + P4,974 = P19,974

Upper control limit = 3 x P4,974 + P15,000 = P29,922

E5 Dynamic Vault Cash Planning

PeopleBank Vault Cash Planning 1998 ($, thousands)

End of Month

∆ Vault Cash

Ending Cash Before Shipments

Target, End of Month

Order

Dec. 149 1,172 1,023

Jan. -1,022 150 5,648 5,498

Feb. -5,498 150 5,369 5,219

March -5,219 150 6,737 6,587

April -6,587 150 150 0

May 5,209 5,359 150 -5,209

June 16,620 16,770 150 -16,620

July 24,202 24,352 150 -24,202

Aug. 16,693 16,843 1,293 -15,550

Sept. -1,143 150 11,819 11,669

Oct. -11,669 150 18,193 18,043

Nov. -18,043 150 7,147 6,997

Dec. -6,997 150 150 0


GTZ 23

E6 PeopleBank, Total Vault Cash Change Before Shipments 1998 ($, thousands)

Jan Feb Mar April May June July Aug Sep Oct Nov Dec Total

Financial Activities ∆ Deposits -3,091 -2,230 -737 -3,586 1,118 5,866 6,532 7,210 85 -1,562 -2,566 -1,006 6,033 ∆ Loans 2,150 -3,198 -4,451 -3,003 4,209 10,928 17,924 9,952 -670 -9,555 -15,016 -5,617 3,653 Loan interest 3,634 3,641 3,691 3,740 3,732 3,632 3,443 3,259 3,198 3,265 3,427 3,563 42,225 Deposit interest -874 -861 -843 -832 -818 -809 -833 -875 -922 -947 -942 -928 -10,484 Interest on long-term debt

0

Cash loan loss -1,533 -1,536 -1,557 -1,578 -1,574 -1,532 -1,452 -1,375 -1,349 -1,377 -1,446 -1,503 -17,812 ∆ Cash from financial activities

286 -4,184 -3,897 -5,259 6,667 18,085 25,614 18,171 342 -10,176 -16,543 -5,491 23,615

Operating Expenses

Non-interest revenue

87 87.9 88.5 89.4 90.3 91.2 92.1 93 93.9 94.5 95.4 96.6 1,100

Salaries & benefits -1,220 -1,225 -1,230 -1,235 -1,364 -1,370 -1,376 -1,381 -1,387 -1,392 -1,398 -1,404 -15,982 Other oper. exp. -175 -177 -180 -182 -184 -186 -188 -190 -192 -195 -197 -199 -2,245 ∆ Cash from operating expenses

-1,308 -1,314 -1,322 -1,328 -1,458 -1,465 -1,472 -1,478 -1,485 -1,493 -1,500 -1,506 -17,127

Long-term Inv./Fin.

Taxes Bonds Construction Capital Real Estate 60 60 ∆ Cash long-term inv. & fin.

60 60

Total ∆ Cash -1,022 -5,498 -5,219 -6,587 5,209 16,620 24,202 16,693 -1,143 -11,669 -18,043 -6,997 6,548

Total Cumulative ∆ Cash

-1,022 -6,520 -11,739 -18,325 -13,116 3,504 27,706 44,399 43,256 31,588 13,545 6,548

Documents

Liquidity Management: A Self Study Guide · Liquidity Management: Extended course Lesson 6 GTZ 3 Other Dimensions of Vault Cash Management We should note that, in practice, vault