Skip to main content

Liquidity Management by Banks: Steps and Principles

By October 17, 2023November 9th, 2023FinTech

To make a cash flow forecast, a business must anticipate its revenue from sales for the forecast period. It must also list and add the income from other sources, such as investments, tax refunds, and grants, to get to the total income figure. Now, subtract all cash outflows, such as rent, salary, raw materials, and marketing expenses, from the total income amount to arrive at the forecasted cash flow amount. A global view of the cash forecast helps companies to plan ahead and assess all options to ensure that sufficient liquidity will be available when needed. It also gives companies the information they need to minimize unnecessary costs that might otherwise arise. For example, inadequate visibility over future cash flows might result in a higher cost of funding.

In the example above, the market for refrigerators in exchange for rare books is so illiquid that it does not exist. Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. Consequently, the availability of cash to make such conversions is the biggest influence on whether a market can move efficiently.

When the promises for depositors as and when presented) come due, and the bank must make payments in cash or equivalent funds. The articles and research support materials available on this site are educational and are not intended to be investment or liquidity management tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Basel III is a set of international banking regulations aimed at enhancing the global financial system’s stability.

Liquidity management definition

So, while volume is an important factor to consider when evaluating liquidity, it should not be relied upon exclusively. If investments are planned, these must also be included in the planning, i.e. when the investment will be made, when you will receive a loan and how high the loan instalments are that you have to pay back each month. Learn how to overcome AP issues by optimizing your purchasing process
for today’s business reality. The difference between interest received from the borrowers and the interest given to the depositors is known as the spread. The higher the spread, the higher the profit banks can cam after meeting expenses about transactions and other related expenses.

  • If the uses of funds are greater than the actual collection of funds, a liquidity gap arises.
  • This allows companies to plan for significant capital expenditures, debt repayments, and other strategic initiatives that may impact their liquidity position.
  • One alternative could be longer-term repo or reverse repo operations (beyond 14 days and up to one year), as they do not have a discernible impact on bond yields.
  • It is an on-going process to ensure that cash needs can be met at reasonable cost in order for a bank to maintain the required level of reserves with RBI (CRR) and to meet expected and contingent cash needs.
  • Also for those firms operating across national boundaries, cross-currency transactions can be unpredictable, with fluctuations in exchange rates making it difficult to accurately ascertain exactly how much a cash inflow or outflow will be.

During boom conditions, the central bank, in its bid to control inflationary pressure, will very likely impose a maximum interest rate that may be paid. The country’s economic situation also conditions the liquidity character of self-liquidating loans. In periods of economic depression, goods do not move speedily into normal trade channels or move at a meager price. The bank can make other loans without liquidity or maturity gave the good quality and marketable securities. Broadened security markets in the 1920s and the desire of banks to make long-term loans fostered this theory. As commercial banking is the oldest financial institution, predating savings and loans, insurance companies, and pension funds, the historical approaches were developed primarily for banking.

Also, while undertaking liquidity management operations, a central bank does not change the asset position of the eligible entities but alters the asset mix by swapping an asset of banking system either with reserves or another asset in its balance sheet. Therefore, being eligible for central bank operations structurally affects underlying collateral markets though the extent of impact may be vastly different under ‘normal’ and ‘non-normal’ situations. For example, the decision of the central bank to accept a new instrument as collateral will increase the willingness to create, trade and hold such assets in private balance sheets.

Liquidity management frameworks globally have similarities in terms of design and tools, but several differences also exist as each central bank attempts to accommodate its unique domestic conditions. However, since the Global Financial Crisis (GFC), following the quantitative easing resorted to by many central banks in Advanced Economies (AEs), a clear divergence has emerged between the liquidity management frameworks of AEs and Emerging Market Economies (EMEs). System liquidity may not always remain in deficit even under a ‘corridor’ system if we recognise the possibility that certain events – like persistent capital flows – may render it difficult for the Reserve Bank to absorb liquidity. In such an eventuality it may become necessary to absorb surplus liquidity at rates closer to the policy rate for efficient transmission of monetary policy signals. Liquidity management is premised on the principle that banks are required to hold, at the end of the day, a certain level of cash in their accounts with the central bank, called required reserves.

Liquidity management definition

After the global crisis, the regulators and investors started to look for better financial managers, better policies and access to firms that has abetter liquidity-risk policy. In other words, the firms started to prefer companies that have a better risk management portfolio. Since a bank can realize higher profits from relatively illiquid assets, there is a natural tradeoff between profitability and liquidity. If they fail to do so, the banks will surely face either a liquidity crisis or a profitability crisis. Maintaining judicious trade-off between liquidity and investment sine qua non for profitability and successful survival of the bank. So, banks should maintain the required and necessary liquidity first and then invest the rest of the amount for profit either as a loan and/or as an investment through open markets.

Smaller companies and emerging tech will not have the type of volume traders need to feel comfortable executing a buy order. Liquidity management has become an essential aspect of cash flow management as businesses increasingly look to optimize their working capital. With more companies operating on tight margins, it is critical to understand what liquidity is and how it can be managed effectively. The condition of having enough money on hand to meet financial obligations without having to sell fixed assets, such as machinery or equipment.

On the other side, if banks invest the largest portion of their funds without maintaining needed adequate liquidity, depositors and other creditors will become impatient and react adversely, which creates panic among the public members. So banks grant credits at a higher rate of interest from the borrowers than the interest banks pay off depositors. Above mentioned ratios of a bank are compared with the whole banking industry to estimate the liquidity needs. In addition to this, banks may estimate the future liquidity requirement by analyzing specific ratios’ past trends and movements. On the other hand, the liquidity manager will manage the cheapest source to fulfill the deficit liquidity in the 2nd, 3rd, 4th, and 6th weeks.

All companies and governments that have debt obligations face liquidity risk, but the liquidity of major banks is especially scrutinized. These organizations are subjected to heavy regulation and stress tests to assess their liquidity management because they are considered economically vital institutions. Here, liquidity risk management uses accounting techniques to assess the need for cash or collateral to meet financial obligations. The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 raised these requirements much higher than they were before the 2008 Financial Crisis. Banks are now required to have a much higher amount of liquidity, which in turn lowers their liquidity risk. For banks, liquidity risk arises naturally from certain aspects of their day-to-day operations.

Due to having a negligible influence on the money market, relatively Smaller banks depend more on near-cash assets than selling securities in the money market. III.9.3 Further, the group also notes that due to unavailability of real-time data on GoI balances, sometimes, market assessment of durable liquidity conditions may not be aligned with that of the Reserve Bank. III.9.1 A clear communication of liquidity management policy and simplifying the framework would help in reducing information asymmetry between the Reserve Bank and market participants.

(iv) It is important that the liquidity management framework does not undermine the price discovery process in the inter-bank money market. Liquidity risk is a financial risk that denotes a company’s inability to meet its financial obligations (short-term debts) on time due to a shortage of liquid cash. A business might go under if it fails to convert its assets into cash when needed, even if its assets exceed its liabilities. So it’s important for businesses to invest in liquidity management tools to anticipate liquidity shortages and ensure that the business can pay its vendors, employees, and debtors on time.

Leave a Reply