Liquidity Management
What is liquidity?
Liquidity is one’s ability to meet
all payment obligations. A financial institution’s liquidity is measured by its
accessibility to sufficient immediately spendable funds at reasonable cost exactly
when needed. For a Bank, liquidity is its instant ability to serve deposit
withdrawal requests from the depositors and loan requests from the customers in
time fashion.
Why liquidity is a vital issue?
Liquidity is considered to be the
lifeblood for a bank. A financial institution is most vulnerable in liquidity
crisis. Depositors are always worried about their cash assets that are
deposited to the commercial banks and a depository bank is bound to return the
deposit amount with agreed interest on demand. If a bank fails to meet the
obligation, worried depositors may launch an old-fashioned ‘run’ on the bank.
When the crisis becomes major, all the depositors may lose confidence, call
back their money at a time and subsequently a bank may fall. Therefore,
liquidity is undoubtedly the prime concern for the bank managers.
A bank may also suffer when it
fails to continue its commitment for continuous credit facility for its
existing borrowers or unable to respond to the new credit applicants due to
liquidity crisis. It may hamper the customer’s confidence; the bank may lose long-term
relationship with the good customers and the prospective customers as well,
which may affect the income severely.
Financial institutions are to
meet huge operating and other expenses like tax. Most of the expenses are subject
to meet immediately. These require liquid assets in a sufficient stock. If a
financial institution fails to meet these expenses due to liquidity shortage,
may hamper the bank’s image; market may receive a wrong message and it may lose
public confidence and regulatory protection.
A FI’s must work for strengthen
the stock value of the firm as well to meet expected dividend demand of the
stockholders even sometimes in cash. If it fails to hold sufficient liquidity,
it cannot fulfill the expectations of the stakeholders.
There is a trade-off between
liquidity and profitability. The more resources are tide for meeting liquidity
demand, the lower the bank’s expected profitability; if all other factors
remain constant. Thus, ensuring adequate liquidity is a never-ending problem
for management that will always have significant implications for
profitability.
Finally, successful liquidity management
is a prudential managerial quality. Maintaining liquid assets in asking level
without keeping much of them in idle may best accelerate a financial
institution to its target. Therefore, liquidity is the most vital issue for the
financial institutions, specially for the banks.
What is Liquidity Management?
Simply liquidity management is a trade-off between the demand for liquidity and supply of liquidity. To explain this process, we can see a FI’s need for liquidity that means the immediately spendable funds in a demand-supply framework.Demand for liquidity:
For banks, the most pressing
demands for spendable funds come from following sources:
1.
Customer’s deposit withdrawal
2.
Credit requests from quality loan customers
3.
Repayment of non-deposit borrowings
4.
Operating expenses and taxes
5.
Payment of stockholder cash dividends
Supply of liquidity:
To meet the foregoing demands for
liquidity, banks can draw upon several potential sources of liquidity supply,
such as:
1.
Incoming deposits
2.
Revenues from non-deposit services
3.
Sales of assets
4.
Borrowing from money market
These various sources of
liquidity demand and supply come together to determine each bank’s net
liquidity position at any moment of time.
A bank’s net liquidity position =
Total supplies of liquidity – Total demand for liquidity
When the result is negative, the
bank is in a liquidity deficit position and when the result is positive, it is
in liquidity surplus position.
The essence of the liquidity
management problem for a bank may be described in two concise statements:
1.
Rarely the demand for liquidity equal to the
supply of liquidity in a particular moment in time. A bank must continually
deal with either a liquidity surplus or liquidity surplus.
2.
There is a trade-off between liquidity and
profitability. The more resources are tide for meeting liquidity demand, the
lower the bank’s expected profitability; if all other factors remain
constant.
Thus, ensuring adequate liquidity
is a never-ending problem for management that will always have significant
implications for profitability.
Why banks face significant liquidity problems?
Liquidity crisis may be generated
from various sources, like as:
- Mismatch of maturities between asset and liability; often banks create long-term assets by short-term liabilities.
- To meet a high volume of payment obligations like as huge amount of fixed deposit withdrawal or payment of money market borrowing
- Sensitivity to changes in interest rate
Strategies of Liquidity Management:
Over the years, experienced liquidity managers
have developed several broad strategies for dealing with liquidity problems.
Generally, we can discuss three broad strategies here as below:
1.
Providing liquidity from assets; Asset Liability
Management Strategy
2.
Relying on borrowed sources to meet cash demand;
Borrowed Liquidity Management Strategy, and
3.
Balanced Liquidity Management Strategy
Asset
Liability Management Strategy
This is the oldest approach to
meet liquidity needs specially used by the smaller banks. This approach calls
for storing liquidity in the form of holding liquid assets, mainly in cash and
various marketable securities. When needed, the selected assets are sold for
cash as much needed. This strategy is also termed as ‘asset conversion’
strategy because of converting noncash assets into cash. These liquid assets
must have some common characteristics, such as:
- It must have a ‘ready market’; so that it can be converted into cash without delay. Example: T-Bill.
- It must have a reasonably ‘stable price’ so that without significant decline in price, it can be sold in any volume and anytime.
- It must be reversible, so that, the seller can recover the original investment with little risk of loss.
The asset conversion strategy is
not a costless approach to liquidity management. When a liquid asset is sold,
it must forego the expected future income as well as incurring some transaction
costs. Prudential management must choose to sell the assets with least profit
potential first in order to minimize the opportunity cost of future earnings.
Borrowed Liquidity Management Strategy
The Liquidity Management Strategy
– in its purest form calls for borrowing enough for immediate spedable funds to
cover all anticipated demands for liquidity. This approach is frequently used
by the banks of our country. In liquidity crisis, they often borrow from money
market and Central Bank.
This borrowed strategy has some
advantages. A bank can decide to borrow actually, when the liquidity shortage is
at the door. The banks need not to store any asset in liquid form and thus it
can bypass the problem of opportunity cost. However, this is a very risky
approach for long time fashion. Money market interest may goes up when most of
the market players face liquidity crisis. This situation is often seen in the
EID season when withdrawing over the counter goes up. Moreover, when a bank run
for cash for long time, it may be marked as problematic one and may have to
face many negative signals from market ends.
Balanced Liquidity Management Strategy
Due to the risks inherent in
relying absolutely on borrowed liquidity and the costs of storing liquidity in
assets, most banks compromise by using both asset management and liability
management strategy. This is known as Balanced Liquidity Management Strategy
where some of the expected demands for liquidity are stored in assets and
unanticipated emergencies tackled by borrowing sources.
What the Managers have to do?
Over the years, experienced
liquidity managers have developed several rules of thumb that guide their plans
for liquidity. The managers should be cautious about the market symptoms and
should have eyes on the following issues:
Firstly, the liquidity manager must keep track on the activities
and future plans of the departments using fund directly. There should have a
practical coordination among the needs and supplies of fund by the separate
departments.
Secondly, the liquidity managers should know in advance, wherever
possible, the possibility of biggest withdrawal or deposit as well as credit
requirements by its customers.
Third, the liquidity managers, in cooperation with the senior
management and Board, must make sure the bank’s priorities and objectives for
liquidity management are clear for smooth decision making to choose the best liquidity
management strategy.
Fourth, liquidity needs and decisions must be analyzed on a
continuing basis to avoid both excess and deficit liquidity positions.
Finally, a bank should maintain adequate data regarding inflow and
outflow of funds to formulate a comprehensive financial process that may help
statistical processing, identifying, directing, and forecasting of liquidity
particulars.
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