Sources and Uses of Funds Approach

One of the key challenges and goals of financial institutions is to stay liquid and provide liquidity
even through turbulent economic times. A financial firm has to estimate the foreseeable supply
and demand of liquidity throughout a given timeframe and has to ensure that the financial
institution will have a surplus of liquidity. One of the tools the liquidity managers of such
institutions have is called the sources and uses of funds.
The sources and uses of funds is essentially a cash flow statement for financial firms, that states
all of the cash inflows and outflaws. In terms of liquidity, the biggest items on the list in the case
of liquidity inflows are deposits and for liquidity outflaws they are loans. A bank (or any other
financial institution dealing with loans and deposits) has to adequately manage these inflows and
outflows to achieve a surplus of liquidity in a similiar way such firms have to manage and strive
for a positive IS GAP. The first step a liquidity manager has to take in ensuring proper liquidity
is to carefully asess the upcoming economic period and the changes in supply and demand for
funds. The first and foremost factor affecting loans is the GDP growth of the given economy. If
the economy is growing, participants are more motivated and inclined to take out loans to start
businesses or to invest into already booming ones. A healthy and growing economy promotes
loans, and it is up to the financial firm to decide how much of the liquidity inflows will be
converted into deposits. However, an increase in corporate earnings can take away from the
willingness to take on loans, as businesses with enough retained earnings might avoid taking the
added risk of debt and leverage and finance their expansions from their own equity. Also,
liquidity inflows and outflows are also extremely susceptible to changes in interest rates and
inflation. In a low interest rate environment, people are more than happy to take out loans
because of the cheap credit available, however less deposits will be made as a low interest rate
environment means that money sitting in financial institutions as deposit yield less, meaning that
people will chase after higher yielding, more riskier investments. Overall, the monetary policy of
the central bank and the growth/stagnation/decline of the economy all have a great impact on the
supply and demand for both loans and deposits, and liquidity managers have to accurately
predict and hedge against these possible interferences and events.
After taking all factors into consideration and asessing the foreseeable changes in loans and
deposits, the final step in finding out the liquidity position of the financial institution is
calculating the difference between the estimated changes in deposits and loans. Of course, to get
the most accurate and complete cash flow statement, liquidity managers must take all sources of
cash inflows and outflaws into consideration and not just loans and deposits, even though these
two have the biggest impact on liquidity position of the bank.
Sources:
Rose, P. S. and Hudgins, S. C. (2012). Bank Management and Financial Services. 9th ed.
Boston: McGraw-Hill.
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