Chapter 13

Bank Liqudity Management

1. Bank liquidity, its essence and importance
Liquidity for a bank means the ability to meet its financial obligations as they come due.   Bank lending finances investments in
relatively illiquid assets, but it funds its loans with mostly short term liabilities.   Thus one of the main challenges to a bank is
ensuring its own liquidity under all reasonable conditions. 

Bank Liquidity of bank may be defined as the ability to meet anticipated and contingent cash needs. Cash needs arise from
withdrawal of deposits, liability maturities and loan disbursals. The requirement for cash is met by increase in deposits and
borrowings, loan repayments, investment maturities and the sale of assets.

A minimum criterion of liquidity is the ability both to meet commitments when due and to undertake new transactions when
desirable.

The need for liquidity arises from:

• Need to replace outflows of funds giving rise to funding risk.

• Need to compensate for the non-receipt of expected inflows of funds giving rise to time risk.

• Need to find new funds when contingent liabilities become due.

• Need to undertake new transactions when desirable giving rise to call risk.

Inadequate liquidity can lead to unexpected cash shortfalls that must be covered at inordinate cost which reduces profitability. It
can lead to liquidity insolvency of the bank without being capital insolvent (negative net worth). A bank has also to avoid
excessive liquidity since it results in low asset yields and poor earnings.
2. Bank's liquid assets and liabilities and their differences
Bank liquid assets are any assets that can quickly be converted into cash with a minimal impact on the asset’s value. In
general, liquid assets are viewed in the same manner as cash, as their value remains largely the same when sold. In order for
an asset to be considered liquid, it must be in an established market, with a large number of interested buyers, and with the
ability for ownership to be transferred easily.
Bank’s liquid assets in balance sheet is called to current assets
Current Assets only consider short-term liquidity in-flow and are thus expected to be due within one year (e.g. cash and cash
equivalents, accounts receivable)
Current assets:
- Cash in hand
- Cash balances at central banks
- Balances with other bank
- Lending to other financial institutions in short-term period
- Government Securities with One Year or Less to Maturity
- Money at Call and Short Notice: mainly of day-to-day loans to the money market
- Short term investment: trading with equity securities
Liquid liabilities
Liability management is based on the purchase of funds necessary to meet deposit withdrawals and loan demands. It enables
the bank to shift funds from lower earning short-term money market instruments to higher earning loans and longer-term
securities. Liability liquidity increases the financial flexibility of the bank in dealing with liquidity needs. It might be cheaper to
acquire funds than liquidate assets. Liability management by increasing debt interest obligations as a percentage of total assets
however increases the interest rate risk as well as the financial risk.
Current liabilities
- Short-term deposit accounts
- Short-term borrowing from other financial institutes
- Accounts and notes payable, accrued liabilities
- Current payments due on the long-term loans.
3. Sources of bank liquidity and its essence
Liability liquidity involves discretionary funds, interbank borrowing, discount window borrowings, repurchase agreements,
certificates of deposit and other borrowing. A bank should enjoy good standing to access these funds. A bank should devise a
liquidity plan or strategy that balances risks and returns. While liquid assets carry less risk, their yield is correspondingly lower.
It does not however have the freedom to reduce deposit rates to match lower returns without losing deposits. Liquidity needs
arising from deposit withdrawals and loan demands can be estimated by preparing a sources and uses of funds statement. The
sources and uses approach can be used to evaluate the effects of deposit inflows and outflows and changing loan demands on
bank liquidity. The structure of deposits method consisting of a list of different types of deposits and the probability of their
withdrawal within a specific planning horizon is another way to estimate liquidity needs. The method focuses on the stability of
deposits as a source of funds.

The sources of liquidity are the maturity structure of the balance sheet (expected outflows of funds matched by expected
inflows of funds) on the assets side, to sell, discount or pledge assets at short notice at minimum cost; and on the liabilities side
ability to raise new money at short notice.

If necessary to pay liquidity by loans, banks can take borrow from the interbank market or the Central Bank; other
borrowed funds, such as deposit certificates and promissory notes.
4. Measurement of bank's solvency and liquidity ratios
Solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt and other obligations. The solvency ratio
indicates whether a bank’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a bank's solvency
ratio, the greater the probability that it will default on its debt obligations.

Liquidity ratio expresses a bank's ability to repay short-term creditors out of its total cash. It is the result of dividing the total
cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater
than 1.00, it means fully covered. Liquidity ratios are most useful when they are used in comparative form. This analysis may
be performed internally or externally. For example, internal analysis regarding liquidity ratios involves utilizing multiple
accounting periods that are reported using the same accounting methods. Comparing previous time periods to current
operations allows analysts to track changes in the business. In general, a higher liquidity ratio indicates that a company is more
liquid and has better coverage of outstanding debts.

The calculation of metrics including the current ratio, quick ratio and liquidity coverage ratio
5. Bank's currency liquidity and its importance
When talking about currency liquidity, we must know that these banks deal with foreign exchange operations and resources.
With foreign currency business (where convertibility exists on current and capital accounts) banks cannot depend on central
bank for liquidity. In a system of floating exchange rates, central banks are not obliged to exchange foreign currencies for
domestic currency at fixed rates or as required by banks. Banks have to provide liquidity entirely from their ability to deal in
financial market and from lines of credit established with other banks.

The foreign exchange (forex) market is often described as the world’s most liquid financial market, and that’s true. But it
doesn’t mean that currencies aren’t subject to varying liquidity conditions that currency traders need to keep in mind. Liquidity
refers to the amount of market interest (the number of active traders and the overall volume of trading) present in a particular
market at any given time. From an bank’s perspective, liquidity is usually experienced in terms of the volatility of price
movements. A highly liquid market will tend to see prices move very gradually and in smaller increments. A less liquid market
will tend to see prices move more abruptly and in larger price increments.

Small banks operating domestically can meet their need for liquidity by holding a portfolio of short-term assets backed by
established facilities for borrowing, whether from central banks or other banks. Small banks have the advantage of the law of
averages in their favor and in normal times they are unlikely to suffer large outflows of money. Large banks also enjoy the
stability provided by large volume of retail deposits a core of which may be regarded as stable. Large banks derive liquidity from
both sides of the balance sheet. They have an active presence in the inter bank as well as wholesales markets which are good
sources of short-term funds. The short-term assets they hold can be sold in case of need and provide reassurance to lenders,
enhancing their borrowing ability.