BANK

MANAGEMENT
CHAPTER 6
LIQUIDITY MANAGEMENT

INTRODUCTION

One of the most important tasks the

management of any financial institution
faces is ensuring adequate liquidity at
all times, no matter what emergencies
may appear
A financial firm is considered to be
liquid if it has ready access to

immediately spendable funds at

a reasonable cost at precisely
the time those funds are needed
2

Cont

Bank has immediate spendable funds:

Bank has adequate cash in hand or, else
Bank is able to immediately convert
liquid
assets into cash
Bank is able to immediately borrow
from outside sources
Lack of adequate liquidity can be one of
the first signs that a financial institution
is in trouble
3

Cont

Liquidity management is far more

important than ever before, because a
bank can be closed if it cannot raise
enough liquidity even though, technically,
it may still be solvent
Moreover, the competence of a banks
liquidity managers is an important
barometer of managements overall
effectiveness in achieving the banks longterm goals
4

The Demand & Supply of

Bank Liquidity
Liquidity demand:
1) Asset side
Credit request from customer
2) Liability side
Withdrawal of deposits
5

Sources of demand and supply

for liquidity
SUPPLIES OF LIQUID
FUNDS

DEMAND FOR
LIQUIDITY

Incoming customer deposit

Customer deposit
withdrawal

Revenue from the sales of

non-deposit services

Credit request from

quality loan customers

Customer loan repayments

Repayment of non-deposit
borrowings

Sales of bank assets

Operating expenses and

taxes

Borrowing from money

market

Dividends for
shareholders
6

cont

Net Liquidity position:

Supplies of liquidity
the bank
flowing into the bank

- Demands on
for liquidity

Cont

Supplies of liquidity flowing into the

bank:

A banks net liquidity position (L t);

= Incoming deposits (inflows)
+ revenues from the sale of nondeposit
services
+ customer loan repayments
+ sales of bank assets
+ Borrowings from the money market
8

Cont

Demands on the bank for liquidity:

-

Deposit withdrawals (outflows)

Volume of acceptable loan requests
Repayments of bank borrowings
Other operating expenses
Dividend payments to bank
shareholders
9

Cont

Liquidity deficits
Total demand for liquidity exceeds
total supply of liquidity (demand >
supply)

Liquidity surplus
Total supply of liquidity exceeds total
demand for liquidity (supply >
demand)
10

Cont
In reality:

1. Rarely are the demands for bank liquidity

equal to the supply of liquidity at any
particular time. Must continually deal
with either a liquidity deficit or a
liquidity surplus.
2. There is a trade-off between bank
liquidity and profitability. The more bank
resources are tied up in readiness to meet
demands for liquidity; the lower is that
banks expected profitability.
11

Cont
So the management of banks liquidity is
subject
to:
1.

Timing
- bankers must plan carefully how, when, and
where needed liquid funds can be raised.

2.

Interest rate risk

- if interest rate rises, financial assets that
the bank plans to sell to raise liquid funds
(eg. bonds) will decline in value.

3.

Availability risk
- the risk that liquid funds will not be
available in the volume needed.

12

Why Banks Face Significant

Liquidity Problems?
1.

2.

Imbalances between the maturity

dates on their assets and the
maturity dates attached to their
liabilities
Example: Maturity on loans are
longer than maturity on deposits
Banks sensitivity to changes in
interest rates (interest rate on loans
and deposits)
13

Strategies for Liquidity

Managers
1.

2.

3.

Asset Liquidity Management (or

Asset Conversion) Strategies
Borrowed Liquidity (Liability)
Management Strategies
Balanced (Asset and Liability)
Liquidity Management Strategies

14

Asset Liquidity Management

(or Asset Conversion)
Strategies

The oldest approach to meeting bank

liquidity needs
It relies on liquid assets that can be
readily sold or converted into cash to
meet liquidity needs.
Also called asset conversion strategy
because liquid funds are raised by
converting non-cash assets (liquid assets)
into cash.
Mostly used by smaller banks that find it
is less risky approach to liquidity
management than relying on borrowings 15

Cont

Three characteristics of liquid assets:

Must have ready market can be
converted into cash without delay
Must have stable price no
significant decline in price
Must be reversible the seller can
recover his original investment
with little risk or loss
16

Cont
Examples of liquid assets:
Cash
Clearing account balances with BNM
Money at call with the discount houses
Treasury bills
Government debt securities
BNM debt securities
Cagamas debt securities and other
approved securities
17

Cont

Asset conversion is not a cost-free

approach to liquidity management:
1. There is an opportunity cost to
storing liquidity in assets when those
assets must be sold
2. Most asset sales also involve
transactions costs (commissions) paid
to security brokers
3. The asset in question may need to be
sold in a market experiencing
declining prices, subjecting the bank
to the risk of substantial capital losses
18

Cont
4.

5.

Weaken the appearance of the

banks balance sheet
The assets sold are often lowrisk government securities (i.e:
T-bills, Government securities)
that give the impression the
bank is financially strong
Liquid assets generally carry the
lowest rates of return of all
financial assets
19

Borrowed Liquidity
(Liability) Management
Strategies

Also called purchased liquidity or

liability management
Rely on borrowed funds to meet
liquidity needs
Most risky approach to solving bank
liquidity problems (but has the highest
expected return) because of the
volatility of money market interest
rates and the rapidity with which the
availability of credit can change

20

Cont

Liability management techniques are

used most extensively by large banks,
which often borrow close to 100 percent
of their liquidity needs

Advantages of borrowing liquid funds:

1.Can borrow when needed
2.Able to borrow without altering
volume and composition of assets
portfolio
3. Easy to obtain by using interest rate
21

Cont
Sources of borrowed liquidity:
1. Negotiable certificates of deposits (NCDs)
2. Borrowing from BNM to cover daily
clearing deficit (Federal funds borrowing)
3. Repurchased agreements (Repos)
4. Eurocurrency borrowing (NCD, overnight,
commercial paper etc)
5. Borrowing at discount window at BNM

22

Cont
Drawbacks:
1. Risky approach because money
market interest rate is highly volatile
2. Must purchase liquidity when it is
most difficult to do so, both in cost
and availability.
3. Other financial institutions are less
willing to lend to bank with chronic
liquidity crisis
4. Uncertain borrowing costs therefore
uncertain net earnings
23

Balance (Asset & Liability)

Liquidity Management
Strategies
Combined use of liquid asset holdings
(asset management) and borrowed
liquidity (liability management) to
meet liquidity needs.
Unexpected liquidity needs met from
short-term borrowing
Longer term liquidity needs are
properly planned (line of credit with
banker, standby credit, etc)

24

Guidelines for Liquidity

Managers
1.

The liquidity manager must keep track of

the activities of all departments using
and/or supplying funds while coordinating
his or her departments activities with
theirs.

Whenever the loan department grants

a new credit line to a customer, the
liquidity manager must prepare for
possible drawings against that line.
25

Cont
2.

3.

Liquidity needs and liquidity decisions

must be analyzed on a continuing basis to
avoid both excess and deficit liquidity
positions.
The liquidity manager should know in
advance, wherever possible, when the
biggest creditor or deposit customers
plan to withdraw their funds or add to
their deposits.
This allows the manager to plan ahead
to deal more effectively with emerging
liquidity surpluses and deficits
26

Cont
4.The
liquidity
manager,
in
cooperation
with
senior
management and the BOD, must
make sure the bank or other
financial
firms priorities and
objectives for liquidity management
are clear.

27

ESTIMATING BANKS
LIQUIDITY NEEDS
Approach in estimating a banks
liquidity needs:
1. The Sources and Uses of Funds
Approach
2. The Structure of Funds Approach
3. The Liquidity Indicator Approach
4. Signals from the marketplace
28

1. SOURCES AND USES OF

FUNDS APPROACH

Begins with two simple facts:

1. Bank liquidity rises as deposits
increase and loans decrease
2. Bank liquidity declines when
deposits decrease and loans
increase
29

Cont

Whenever sources and uses of liquidity do not

match, the bank has a liquidity gap
Liquidity gap measured by the size of the
total difference between its sources and uses
of funds
Positive Liquidity Gap (Surplus)
Sources of liquidity (i.e., increasing deposits
or decreasing loans) exceed uses of liquidity
(i.e., decreasing deposits or increasing loans)
Its surplus liquid funds must be quickly
invested in earning assets until they are
needed to cover future cash needs
30

Cont

Negative Liquidity Gap (Deficit)

Uses of liquidity exceed sources of
liquidity
Bank must raise funds from the
cheapest and most timely sources
available

31

Cont

Key steps in the sources and uses of

funds approach:
1. Loans and deposits must be forecast
for a a given liquidity planning period
2. The estimated change in loans and
deposits must be calculated for that
same planning period
3. The liquidity manager must estimate
the banks net liquid funds, surplus
or deficit, for the planning period by
comparing the estimated change in
loans to the estimated change in
deposits
32

cont
How to forecast deposits and loans?
1. Trend component
Construct trend or long run average growth rate
in
deposits and loans using specified reference
points
(yearly, quarterly period, yearly figures for last 10
years or more).
2. Seasonal component
How deposits and loans respond in any given
week or month due to seasonal factors as
compared to the most recent year-end deposit or
loan level.
33

Cont
3.

Cyclical component
Represents positive or negative deviations
from a banks total expected deposits and
loans (measured by the sum of trend and
seasonal components), depending upon
the
strength or weakness of the economy in
the current year.

34

2. Structure of Funds
Method
1.

Banks deposit and nondeposit

liabilities will be divided into three
categories:
i. Hot money liabilities
ii. Vulnerable funds
iii. Stable funds

35

3. Liquidity Indicator
Approach
1.

Cash position indicator

Cash and deposit due from depository
institutions
Total asset

2. Liquid securities indicator

Government securities
Total assets
36

Cont
3.

Capacity ratio
Net loans and leases
Total assets

4. Core deposit ratio

Core deposits
Total assets
37

Cont
5.

Deposit composition ratio

Demand deposits
Time deposits

38

4. Signals from the

Marketplace
Management should look at these signals:
1. Public confidence
2. Stock price behavior
3. Risk premiums on CDs and other
borrowings
4. Loss sale of assets
5. Meeting commitments to credit
customers
6. Borrowings from the central bank
39

MALAYSIA

In an effort to enhance liquidity

management in banking institutions,
Bank Negara Malaysia introduced the
Liquidity Framework in 1998 to
replace the liquid asset ratio
requirement.
The Liquidity Framework is applicable
to all banking institutions licensed
under the Banking and Financial
Institutions Act 1989 (BAFIA)
40

Cont

The Framework sets out to: create awareness among banking

institutions of their funding structure and
their ability to handle short to mediumterm liquidity problems;
adopt a more efficient and on going
liquidity measurement and management
for banking institutions; and
provide the Bank with a better means of
assessing the present and future liquidity
position of banking institutions
41