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.

• 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

What is Liquidity?

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

services

Sales of Borrowings + banks + 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 SurplusWhen 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

When sources of liquidity exceed uses of liquidity, the bank will have a positive liquidity gap

Negative Liquidity Gap

When uses of liquidity exceed sources of liquidity, the bank will have a 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 liabilitiesCore deposit ratioCore 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