Liquidity

Management
•The purpose of this chapter is to explore the
reason’s why financial institutions often face
heavy demands for immediately spendable funds
(liquidity) and learn about the methods they can
use to prepare for meeting their cash needs.
 What is Liquidity?
• Availability of Cash in the amount
and at the time needed and at a
reasonable cost
• A bank is considered to be liquid if it
has ready access to immediately
spendable funds at reasonable cost
 Demands for Liquidity

• Customer Deposit Withdrawals

• Credit Requests from Quality Loan
Customers
• Repayment of Nondeposit Borrowings
• Operating Expenses and Taxes
• Payment of Stockholder Dividends
 Demand on the Bank for Liquidity

Deposit Volume of Repayments

withdrawals + acceptable + of Bank

(outflows) loan requests Borrowings

Other Dividend
+ operating + payments
expenses to bank
stockholders
 Supplies of Liquid Funds

• Incoming Customer Deposits

• Revenues from the Sale of
Nondeposit Services
• Customer Loan Repayments
• Sales of Bank Assets
• Borrowings from the Money Market
Supply of Liquidity Flows into the Bank

Incoming Revenues from Customer

deposits + the sale of + loan

(inflows) nondeposit repayments

Sales of Borrowings
+ banks
services
+ from the
assets money Market
 Bank’s Net Liquidity Position

Supply of Liquidity Flows into the

Bank

minus

Demands on the Bank for Liquidity

 Liquidity Deficit and Surplus
When the bank's total demand for liquidity
exceeds its total supply of liquidity,
management must prepare for a liquidity
deficit, deciding when and where to raise
additional liquid funds.

When the total supply of liquidity to the bank

exceeds its liquidity demands, management
must prepare for a liquidity surplus, deciding
when and where to profitably invest surplus
liquid funds.
 Essence of Liquidity Management

• Rarely are the Demands for Liquidity Equal to the

Supply of Liquidity at Any Particular Moment. The
Financial Firm Must Continually Deal with Either a
Liquidity Deficit or Surplus
• There is a Trade-Off Between Bank Liquidity and
Profitability. The More Resources are Tied Up in
Readiness to Meet Demands for Liquidity, the Lower
is the Financial Firm’s Expected Profitability.
 Why Banks and Their Competitors
Face Significant Liquidity Problems

• Imbalances Between Maturity Dates of

Their Assets and Liabilities
• High Proportion of Liabilities Subject to
Immediate Repayment
• Sensitivity to Changes in Interest Rates
 Strategies for Liquidity Management
 Asset Liquidity Management or Asset
Conversion Strategy

 Borrowed Liquidity or Liability

Management Strategy

 Balanced Liquidity Management

 Asset Liquidity Management
• Reliance on liquid assets that can be
sold readily for cash to meet a bank’s
liquidity needs.
• When liquidity is needed selected
assets are sold until all the demand for
cash are met
• Also called Asset Conversion strategy
as liquid funds are raised by converting
non cash assets into cash
 Liquid Asset

• Must Have a Ready Market so that it

Can Be Converted to Cash Quickly
• Must Have a Reasonably Stable Price
• Must Be Reversible so that the seller
Can Recover Original Investment
with Little Risk of Loss
 Asset Liquidity Management
• The strategy is mainly used by smaller banks
that find it a less risky approach
• Asset conversion is not a cost less approach to
liquidity management
• There is opportunity cost to storing liquidity in
assets when those assets must be sold.
• Transaction cost
• Potential Capital loss
• Relatively Lower Return
 Options for Storing Liquidity
• Treasury Bills
• Other Govt. Securities
• Money Market Loan
• Repurchase Agreement
• Inter-bank Market
• Bankers’ Acceptances
• Commercial Paper
 Costs of Asset Liquidity
Management

• Loss of Future Earnings on Assets That Must Be

Sold
• Transaction Costs on Assets That Must Be Sold
• Potential Capital Losses If Interest Rates are
Rising
• May Weaken Appearance of Balance Sheet
• Liquid Assets Generally Have Low Returns
 Liability Liquidity Management
• Reliance upon borrowed funds to meet
a bank’s liquidity needs.
• Also knows as Borrowed Liquidity or
Purchased Liquidity strategy.
• It calls for borrowing enough
immediately spendable funds to cover
all anticipated demands for liquidity.
 Advantages of Liability Liquidity
Management

• A bank can borrow only when there

is need
• Allows a bank to keep its volume
and composition of asset portfolio
unchanged
• Allows a bank using interest rate
as a control variable
 Borrowing Liquidity :
The Principal Options
• Borrowing from bank reserves and other
money market lenders
• Selling liquid or low risk securities under a
repurchase agreement
• Issuing CDs to major corporations or
government units [from few days to several
months]
• Borrowing reserves from the discount window
of central bank
Risks involved in Borrowing Strategy
• Borrowing liquidity is the most risky
because of the volatility of money
market interest rate.
• Borrowing cost is uncertain that adds
uncertainties to bank’s net earnings.
• If the bank is in trouble in collecting
funds, other institutions become less
interested to lend to it and depositors
begin to withdraw their funds
 Balanced Liquidity Management
• Combined use of liquid asset
holdings and borrowed liquidity.
• Due to inherent risk in relying on
borrowed liquidity and costs of
storing liquidity in assets, most
bank use a combination of the two
strategies.
Balanced Liquidity Management
• Under the strategy some of the
expected demands for liquidity are
stored in assets, while other
anticipated liquidity needs are
backstopped by advance
arrangements for lines of credit
from correspondent banks or other
suppliers of funds.
 Guidelines for Liquidity Manager

• The liquidity manager must keep track

of all fund raising and fund using
departments and coordinate with his
departments and their activities
• The liquidity manager should know in
advance when the bank’s big customers
plan to withdraw funds or add to
deposits
 Guidelines for Liquidity Manager

• The liquidity manager in cooperation

with senior management and board,
must make sure that bank’s priorities
and objectives for liquidity management
are clear.
• The bank’s liquidity needs and liquidity
decisions must be analyzed on a
continuing basis to avoid both excess
and deficit liquidity position.
 Estimating a Bank's Liquidity Needs

• Sources and uses of funds

approach
• Structure of funds approach
• Liquidity indicator approach
Sources and uses of funds approach

It begins with two simple facts:

• Bank liquidity rises as deposits increase and
loans decrease [sources of fund]
• Bank liquidity declines when deposits
decrease and loans increase [uses of fund]

• The method is for estimating a bank’s

liquidity requirements by focusing primarily
on expected changes in Deposits and Loans.
 Sources and uses of funds approach
• Whenever sources and uses of liquidity do not
match, the bank has a liquidity gap, measured
by the size of the total difference between its
sources and uses of funds.

Positive Liquidity Gap Negative Liquidity Gap

When sources of When uses of

liquidity exceed uses liquidity exceed
of liquidity, the sources of liquidity,
bank will have a the bank will have a
positive liquidity gap Negative liquidity gap
 The key steps in the sources and uses of
funds approach

• Loans and deposits must be forecasted

for a given liquidity planning period.
• The estimated change in loans and
deposits must be calculated for that
same planning period.
• The liquidity manager must estimate
the bank's net liquid funds’ surplus or
deficit, for the planning period.
 Estimated liquidity deficit or surplus

• Estimated change in total loans for the coming

period is a function of projected growth rate
in the economy, projected quarterly corporate
earnings,growth rate of money supply, bank
loan rate and estimated inflation rate.
• Estimated change in total deposits in the
coming period is a function of growth in
personal income, estimated increase in retails
sales, growth rate of money supply, projected
yield on money market deposits and estimated
inflation rate.
 Estimated liquidity deficit or surplus

• Estimated liquidity deficit or

surplus = Estimated change in
total deposit-Estimated
change in total loans
 The Structure of Funds Approach

The method is for estimating

a bank’s liquidity needs by
dividing its borrowed funds
into categories based upon
their probability of
withdrawal.
.
Bank’s deposit and nondeposit liabilities
may be grouped into three categories
• Hot money liabilities(Volatile liabilities)—
deposits and other borrowed funds that are
very interest sensitive or that management
is sure will be withdrawn during the current
period.
• Vulnerable funds—customer deposits of
which a substantial portion will probably be
removed from the bank sometime during
the current time period.
• Stable funds (often called core deposits or
core liabilities)—funds that management
considers most unlikely to be removed
from the bank
 The Structure of Funds Approach

Liquidity manager must set aside liquid funds

according to some desired operating rule. For
example, the manager may decide to set up a
95 percent liquid reserve behind all hot
money funds . This liquidity reserve might
consist of holdings of immediately spendable
deposits in correspondent banks plus
investments in Treasury bills etc.
 A Suggested Rule for Liability Liquidity
Reserve

Liability Liquidity Reserve= 0.95(Hot

money deposits and non deposit
funds-Legal reserves held)+ 0.30
(Vulnerable deposit and non
deposit funds-Legal reserves held)+
0.15(Stable deposits and non
deposit funds-Legal reserves held)
 Loan Liquidity Requirements

The bank must be ready at all times to

make god loans. The bank must have
sufficient liquid reserves on hand
because, once a loan is made, the
borrowing customer will spend the
proceeds and those funds will flow
out to other depository institutions.
A Suggested Rule for Total Liquidity Reserve
Liability Liquidity Reserve= 0.95(Hot
money deposits and non deposit funds-
Legal reserves held)+ 0.30 (Vulnerable
deposit and non deposit funds-Legal
reserves held)+ 0.15(Stable deposits and
non deposit funds-Legal reserves held)
+1.00(Potential Loan Outstanding- Actual
Loan Outstanding)
The above equation is subjective estimate
that rely heavily on management’s
judgment, experience and attitude
toward risk.
 Liquidity Indicator Approach

• Some banks estimate their liquidity

needs based on experiences and
industry average.
• The indicator approach deals with
ratios or other measures of changes in
a bank’s liquidity position.
 Some Liquidity Indicators
• Cash position indicator
Cash and deposits due from
depository institutions / Total Assets

• Liquid securities indicator

Government Securities / Total Assets
• Capacity ratio
Net loans and leases/Total Assets
 Some Liquidity Indicators
• Hot money ratio:Money market
assets(Short-term)/Volatile liabilities
Core deposit ratio
Core deposits/Total assets, where core
deposits are defined as total deposits
less all deposits over $100,000. Core
deposits are primarily small-
denomination accounts from local
customers that are considered unlikely
to be withdrawn on short notice and so
carry lower liquidity requirements.
 Some Liquidity Indicators
• Deposit composition ratio:Demand
deposit/time deposits, where demand
deposits are subject to immediate
withdrawal via check writing, while time
deposits have fixed maturities with
penalties for early withdrawal. This
ratio measures how stable a funding
base each depository institution
possesses; a decline in the ratio
suggests greater deposit stability and,
therefore, a lessened need for liquidity.
 The Ultimate Standard for Assessing Liquidity
Management: Signals from the Marketplace

• Public confidence
• Stock price behavior
• Risk premiums on CDs and other borrowings
• Loss sales of assets
• Meeting commitments to credit customers
• Borrowings from the central bank