Overview
Banks are financial organizations that borrow money in the form of deposits and lend to customers who have more immediate spending needs. The money borrowed by a bank is listed as the liabilities of the bank, and the loans made are the banks assets. When a bank's assets are worth more than the banks liabilities, the bank is solvent.
However, the bank's liabilities will require the bank to pay cash at various times. Sometimes these dates are known contractually through a term contract, but often times, these pay dates are random, as when a liability is an on demand deposit and the customer can withdraw at any time.
If the bank's assets are locked up entirely as loans, it may not have cash available when needed. This means that the bank can be solvent and yet still fail to meet its required payments. This is the issue of liquidity. Liquidiy is a measure of how easily the bank's assets can be turned into cash in order to make a required cash payment. A bank needs enough liquidity to meet its obligations.
Liquid assets typically don't pay very well, so a bank wants to hold illiquid loans or other securities in order to make profits. This means that the bank engages in a balancing act between higher profits, and more liquidity.
Measuring Liquidity
There are multiple ways one can go about measuring and controlling liquidity.
- The Basel III Accords provided a set of simple ratios for measuring and managing liquidity.
- Deposit Modeling is the process of creating a statistical model of a bank's deposits in order to forecast average levels and withdrawals.
Managing Liquidity
There are two primary techiniques for managing the liquidity and/or cash position of the bank.
- Maintain a Liquid Asset Buffer - that is, keep a group of assets in the portfolio that are highly liquid and retained mostly for their liquidity. These assets are typically high quality sovereign debt, that are liquid even during financial crises.
- Trade the Portfolio - as the liquidity needs of the bank goes up or down, the Treasurer can trade assets in the portfolio in order to generate cash, or trade excess liquidity for yield. A common method of raising cash is to repo some assets.
Sources of Liquidity
When a bank considers its liquidity position, it doesnt just focus on how much cash on hand it has. This is because, it has outstanding loans and other sources which will product cash over time. This means that the issue of building a liquidity buffer must forecast both probable cash inflows and outflows over time.
The following represent sources of liquidity for the bank:
- Cash Reserves
- Cash flow from Operations
- Assets that are sold for cash
- New Deposits
- Bank Borrowings and Issuance of Debt
- Other cash sources (example funding from new equity)
In general, these sources are usually categorized within 3 different categories
- Operating Cash Flow
- Asset liquidity - cash reserves and liquid assets
- Funding liquidity - ability to raise cash through additional borrowings
Liquidity Ratios
When analyzing a banks liquidity position from its financial statements and call reports, analysts often look at the following ratios.
- Liquid Assets Ratio - Total Liquid Assets / Total Assets
- Net Loans to Total Assets
- Customer Deposits to Total Deposits
- Loans to Deposits
- Loans to Customer Deposits