Week 13 & 14

Chapter 6: Liquidity
Management
Chapter Objectives
 Understand the basic concepts and importance of
liquidity management in banking.
 Learn about the objectives and goals of liquidity
management, including maintaining sufficient liquidity to
meet obligations and optimizing the use of funds.
 Identify the different types of liquidity, including funding
liquidity and market liquidity.
 Explore the principles and theories of liquidity
management practiced by modern commercial banks.
What is Liquidity of a Bank?

Liquidity for a bank means the ability

to meet its financial obligations as they
come due.

It can come from direct cash holdings

in currency or on account at the
Federal Reserve or other central bank.

More frequently, it comes from

acquiring securities that can be sold
quickly with minimal loss.
Need for Liquidity of a Bank?

To meet the obligations of the customer on a timely

basis under both normal and stressed conditions.

To perform day to day operation.

To take the opportunity short term profitable

investment.

To avoid operational and financial risks.

To maintain high reputation in the marketplace .

Types of Liquidity in the
Banking system

Funding liquidity: this relates to the ability of

banks to pay their debts when they are due.

Central bank liquidity: this relates to funding

provided to market participants.

Market liquidity: this relates to the ability of

investors to trade assets in the market (for
example, an asset is liquid if it can be easily sold in
large amounts with only small changes in its price).
 How Can a Bank Achieve
Liquidity
Shorten asset maturities
• Give out loan for short period of time.

Improve the average liquidity of assets

• Invest more on securities as they more liquid than loans and other assets.

Lengthen liability maturities

• The longer duration of a deposit, the less it is expected that it will mature
while a bank is still in a cash crunch.
Issue more equity
• Raised capital in the form of equity than liability

Reduce contingent commitments

• Cutting back the amount of lines of credit and other contingent commitments
to pay out cash in the future.
 Liquidity Management
 This is both an art and a science of managing liquid asset
in order to meet up the up coming obligations.

Major Current Assets Bank Current Liabilities

1. Investment in Securities 1. Banks borrowing from
in short term securities. Other banks.
2. Cash Reserve 2. Saving deposit.
3. Short term loan 3. Current deposit
 Principles of Liquidity
Management
A. Banks must develop a structure for liquidity
management
 1. Each banks should have an agreed strategy for day-to-
day liquidity management. This strategy should be
communicated throughout the organization.
 2. A Bank Governing board should approve the strategy
and significant policies related to liquidity management.
The governing board should also ensure that senior
management of the bank takes the steps necessary to
monitor and control liquidity risk
 Principles of Liquidity
Management
3. Each Bank should have a management structure in place
to effectively execute the liquidity strategy. This structure
should include the on-going involvement of members of
senior management.
4. Banks must have adequate information systems for
measuring, monitoring, controlling and reporting liquidity
risks.
 Principles of Liquidity
Management
B. Banks must measure and monitor net funding
requirements
1. Each bank should establish a process for the ongoing
measurement and monitoring of net funding requirements.
2. Banks should analyze liquidity utilizing a variety of
scenarios.
C. Banks should Manage market access
Each banks should periodically review its efforts to
establish and maintain relationships with liquidity holders,
to maintain the diversification of liabilities, and aim to
ensure its capacity to sell assets
 Principles of Liquidity
Management
D. Banks should have contingency plans
A bank should have contingency plans in place that
address the strategy for handling liquidity crises and which
include procedures for making up cash flow shortfalls in
emergency situations.
E. Banks should manage their foreign currency
Liabilities
Each bank should have measurement, monitoring and
control system for its liquidity positions in the major
currencies in which it is active.
 Liquidity Management Theory
1. Commercial Loan Theory
 The commercial loan theory states that a commercial
bank should forward only short-term self-liquidating
productive loans to business organizations.
 Loans meant to finance the production, and evolution
of goods through the successive phases of production,
storage, transportation, and distribution are considered
as self-liquidating loans.
 This theory also states that whenever commercial
banks make short term self-liquidating productive loans,
the central bank should lend to the banks on the
security of such short-term loans.
 Liquidity Management Theory
Advantages
 First, they acquire liquidity so they automatically liquidate
themselves.
 Second, as they mature in the short run and are for
productive ambitions, there is no risk of their running to
bad debts.
 Third, such loans are high on productivity and earn
income for the banks.
Disadvantages
First, if a bank declines to grant loan until the old loan is
repaid, the disheartened borrower will have to minimize
production which will ultimately affect business activity
Liquidity Management Theory
2. Shiftable Theory
 This theory was proposed by H.G. Moulton who
insisted that if the commercial banks continue a
substantial amount of assets that can be
moved to other banks for cash without any
loss of material. In case of requirement, there is
no need to depend on maturities.
 This is specifically used for short term market
investments, like treasury bills and bills of exchange.
 But in general circumstances when all banks require
liquidity, the shiftability theory need all banks to
acquire such assets which can be shifted on to the
central bank which is the lender of the last resort.
Liquidity Management Theory
 Advantage
The shiftability theory has positive elements of truth. Now
banks obtain sound assets which can be shifted on to other
banks. Shares and debentures of large enterprises are
welcomed as liquid assets accompanied by treasury bills and
bills of exchange.
 Disadvantage
Firstly, only shiftability of assets does not provide liquidity
to the banking system. It completely relies on the economic
conditions.
Liquidity Management Theory
 Secondly, the shares and debentures cannot be
shifted to others by the banks. In such a situation,
there are no buyers and all who possess them want
to sell them.,
 Third, a single bank may have shiftable assets in
sufficient quantities but if it tries to sell them when
there is a run on the bank, it may adversely affect the
entire banking system. Fourth, if all the banks
simultaneously start shifting their assets it would have
disastrous effects on both the lenders and the
borrowers.
Liquidity Management Theory
Anticipated Income Theory
 This theory states that irrespective of the nature
and feature of a borrower’s business, the bank plans
the liquidation of the term-loan from the expected
income of the borrower. A term-loan is for a period
exceeding one year and extending to a period less
than five years.
 It is admitted against collateral. The bank puts
limitations on the financial activities of the borrower
while lending this loan.
Liquidity Management Theory
 While lending a loan, the bank considers security
along with the anticipated earnings of the borrower.
So a loan by the bank gets repaid by the future
earnings of the borrower in installments, rather
giving a lump sum at the maturity of the loan.
Liquidity Management Theory
 Advantages
It satisfies the three major objectives of liquidity, safety
and profitability. Liquidity is settled to the bank when
the borrower saves and repays the loan regularly after
certain period of time in installments. It fulfills the
safety principle as the bank permits a relying on good
security as well as the ability of the borrower to repay
the loan.
The bank can use its excess reserves in lending term-
loan and is convinced of a regular income. Lastly, the
term-loan is highly profitable for the business
community which collects funds for medium-terms.
Liquidity Management Theory

Disadvantages
 The theory of anticipated income is not free from
demerits. This theory is a method to examine a
borrower’s creditworthiness. It gives the bank
conditions for examining the potential of a borrower to
favorably repay a loan on time.
 It also fails to meet emergency cash requirements.
Thanks