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FRM Part II · FRM Exam Part II · Liquidity and Reserves Management: Strategies and Policies

A treasurer wants to reduce the cost of carrying a large liquidity reserve without materially weakening its protective function. Which approach is most consistent with sound reserve management?

Tiering the reserve is the sound approach: the most liquid assets cover near-term needs and slightly less liquid, higher-yielding eligible assets cover later horizons. This cuts carry cost while preserving protection, unlike concentration, using encumbered assets, or procyclically shrinking the buffer.

  1. ATier the reserve so the most liquid assets cover the shortest horizon needs, with less liquid but higher-yielding eligible assets covering later horizonsCorrect
  2. BReplace all central bank balances with a single concentrated position in one issuer's bonds to earn a higher yield
  3. CHold the reserve in assets that are encumbered in long-term secured funding to avoid double counting
  4. DReduce the reserve whenever market funding spreads narrow, since stress is then unlikely

Explanation

Tiering matches asset liquidity to the horizon at which cash is needed, lowering carry cost while keeping immediate liquidity. Concentration raises idiosyncratic and market risk. Encumbered assets are not available as a buffer. Procyclical cuts when spreads are tight leave the bank exposed when conditions reverse.

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