Bank Decisions on Investment Borrowings

Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Considering the high costs associated with cash forecasting, it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. This objective can, however, be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit.

There are, however, a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below:

  • Deposit Withdrawals
  • Credit Accommodation
  • Profit fluctuation

The liquidity level to be maintained by a bank should firstly, provide for deposits withdrawals and secondly to accommodate the increase in credit demands. While deposit withdrawals must be honored immediately, it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. Satisfactory credit accommodation ultimately results in more business for the bank.

Liquidity is further influenced by the fluctuation in the business profits of the bank. It has already been explained that any fluctuation in the interest rates may result in an increase decrease in the Net Interest Margin (NIM) of the bank. If this fluctuation results in a negative growth i.e. a decrease in NIM, then the bank should review its RSAs and RSLs. It might thus resort to gap management, which might affect its liquidity position. On the contrary when the profits are showing increasing growth rates, the bank would prefer to maintain higher liquidity position by utilizing the cash balances for investments loan disbursals. This further improves its profitability levels.

Considering these factors, the bank should adjust its surplus deficit to meet the liquidity gap. While surplus funds can be invested in short/long-term securities depending on the bank’s investment policy, the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. If the bank decides to go for liability management then the investment policy ill be long term.

Influencing the strategic issues of bank’s investments are the tactical issues. While the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment which make the strategic policies unsuitable. Implies that if the bank’s strategic policy is liability management, in an increasing interest rate scenario, such a policy will not be advisable. In such a case, the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. Thus, while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing.

Surplus Balance:

In case of a surplus balance, the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. Though holding adequate cash reserves can eliminate the liquidity risk completely, the cost involved in doing so could be prohibitive, especially for a bank. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater.

There are generally 2 options available to the ban while it makes its investment decisions. It can invest either for a short term and roll over until the funds are required for some other purpose of, invest for a longer period after properly assessing the cash requirements through the forecasting process.

IN this decision making process one has to, however, consider/understand the behavior of the yield curves on the long/short-term investments. Yield curves often are sloping upwards since higher interest rates are associated with long term and relatively less liquid assets. For the, expectations theory which explains the relation between the interest rates and the investment period does not hold good in reality. These occurrences explain the fact that the long-term investments do give higher yields than short-term investments. The firm will also have to consider the transaction cost involved while converting its marketable securities.

Deficit Balance:

The second important question that the bank will have to face is, how to meet the deficit cash balances. The only alternative available to meet its deficit is by borrowing funds from the market. While doing this, the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier. In this option, the number of forecasting periods plays a vital role. Internal funds can be effectively used when the cost of borrowing is relatively high.

There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. Two models, which have been commonly used, are the Baumol Model and the Miller and Orr Model. The cash management model given by Baumol extends the Economic Order Quantity concept used in inventory management to discuss the d\cash conversion size, which influences the average cash holding of the firm.

This model analyses the income foregone when the firm holds cash balances (rather than investing the same in the marketable securities), against the transaction costs incurred when the marketable securities are converted into cash. The Miller and Orr model considers that there will be different cash balances at different periods and thus a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash.

Thus, the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. This trade off decision of the bank depends upon its attitude towards the liquidity policy i.e. aggressive/conservative. Depending on the liquidity position to be maintained, the risk preferences and risk factors, management can have a policy which has a relatively large/small amount of liquidity.

Source: Bank Management Notes-MGU