Chapter- 04

Measuring and
Management of Liquidity
 *What is liquidity?
• An individual bank’s liquidity is the ability to
pay depositors on demand, disburse loan
installments as committed and make other
payments as and when due.
• “This (liquidity) means the bank either has the
right amount immediately spendable funds on
(i.e. in its each account) or can raise the
necessary fund by borrowing or by selling
assets.”---Peter S. Rose
 *Liquid assets of bank
• Cash in vault
• Items in the process of collection
• Balance lying in the central bank
• Balance with the sister bank
 *Liquidity Vs Profitability
• Consideration of profitability:
-depositors interest
-loan and investment
• Consideration of liquidity:
• What do the bank need to do?
-bank should maintain required and necessary
liquidity first
- then should invest the rest of the amount for
profit either as loan and or as investment through
open markets.
 *Types of liquidity
1. Immediate liquidity
2. Short-term liquidity
3. Long-term liquidity
4. Contingent liquidity
Beside these there are two more types of liquidity
1. Seasonal liquidity
2. Economic cyclical liquidity
Immediate liquidity
• To meet the depositors demand
• To meet the other daily payables
Short-term liquidity
Liquidity need on the basis of types of clients and
on the seasonal variability-suppose:
• The season of seed sowing of farmers
• Condition of the export import business
• Cultural and religious festivals
Long-term liquidity: this kinds of liquidity generally arises
for some specific projects-
• To meet the cash demand for replacement of fixed assets
• Retirement of the redeemable preferred shares or debenture
• To acquire fixed assets and technical know –how.
Contingent liquidity: Contingent liquidity arises depending on
the happening of some unexpected events-
• To meet the gap due to the sudden transfer of large sized
deposits
• Unexpected large amount of loan demand
• In case of large volume of deposit withdrawals due to the
panic for loss of public confidence, political instability
• Big bank robbery
• Fraud
• Arson or other accidents
• Economic cyclical condition:
• Trough Expansion Peak Contraction

Graph: the cycle of interest rate

• In the time of bad economic conditions and squeezed monetary policy, interest
rate are decrease, eventually increase the supply of money supply—as a result
liquidity demand will increase and bank deposit decreases
• When the economic condition are expanding and strong enough decrease the
supply of money and increase the interest rate—as a result liquidity demand
will decrease and bank deposit increases.
 *The reasons for liquidity crisis of a commercial bank-
• Using short-term funds in long-term investment
• Large proportion of liabilities is repaid in shortest possible of time
• Over sensitiveness to the rate of interest : manage deposit mix and
different types of liquidity.
• Indifference and or lack of cautious and close observation to deposits
and loan behavior of the large prime corporate/institutional
customers; regular contact with prime customer
• Lack of constructive effort to raise the skill of personnel for loan
recovery and loan securitization
• Absence of linkage with the bank rating agencies; govt. bank
regulatory authority, private bank rating agencies, information selling
institutions
• Inaccessibility to the money market; precautionary measures, advance sale of
securities, able to raise call money
• Inefficient front line counter service; efficient, skilled and well-behaved person---
patiently wait without any complain
 *Liquidity management strategies for
banks
• Assets conversion strategies ;
- Such near cash assets, which are convertible to cash within
short notice
- Which are reasonably stable price
- Which can be repurchased by the seller with little risk of loss
• Liabilities management strategies;
• Balanced liquidity management strategies;
 *Theories of liquidity management of
commercial Banking
a) Self- liquidating or real bills doctrine:
• This theory was develop at the end of 18th century
• This theory old and conservative nature
• The main theme of this theory is that bank
provide its fund for short-term business loan those
are automatically converted into liquid assets.
• Provide loan for working capital purpose
• Example; - ‘A’ purchase goods from ‘B’ on credit
- ‘B’ draw a bill to ‘A’ and ‘A’ accept the bill
 Cont….
- ‘B’ show the bill to his bank and take the loan from bank
In this case bank should ensure the following conditions;
- Purchaser will able to sale the goods within certain
period
- Purchaser will pay the payable amount to his seller
- Seller will repay the loan amount to his bank

Self -liquidity theory also called real bill doctrine because;

-involvement of certain commercial transactions( purchase
and sale) and
-optimum certainty of recover the loan amount
 Real bill doctrine
Criticism of real bill doctrine:
1. Old and conservative nature
2. Helpless situation for recession
3. Possibility of inversion in complex situation
4. Limited sector
5. More risk
6. Lack of loan renewal facilities
7. Negative effect on total production
8. Neglected the idea of profit earning
9. Unsafe of loan
10.Neglected the other sources of liquidity
 Cont….
b) Shift ability theory:
-The theory was originated in the USA in 1918 by H.G.Moulton
- The main theme of this theory is that bank will invest a part
of its fund into some assets like; Govt. bond, bill, corporate
share, bond
- These assets can be converted into cash immediately and
easily , without loss or sacrificing profit.
- Under this theory bank want to ensure only clients demand
but consider profitability as negligible matter (like as
commercial loan theory)
Criticism
-Possibility of loss for recession
-Influence of the weakness of banking sector
-Presentation of partial idea
-Excessive dependency on central bank
 Cont….
c) Anticipated income theory:
-The Anticipated income theory was developed in 1944 by
Hervert V. Prochnow.
-In this theory criticized the above two theories-because
they only consider liquidity but ignore profitability.
-According to this theory bank should provide different
terms loan in such a way that loan will recover on the
basis of amortization schedule.
-Bank can be depends on central bank and other financial
institutions if it face any unexpected liquidity crisis.
-In this theory bank provide loan and taking different
securities as collateral
-This theory ensure both liquidity and profitability.
The suitability of This theory was proved by a report of
Redcliffe Committee of England. He was said that term
loan is better than bank overdraft to maintain liquidity
and profitability.
END OF CHAPTER