Describe the objectives involved in the management of a bank\'s overall liquidit

Question

Describe the objectives involved in the management of a bank's overall liquidity position and the costs to the bank of poor liquidity management. In your discussion, identify the major sources of demand on a bank's liquidity position, including reserve requirements, and the major sources of funds to meet liquidity needs. As part of your discussion, consider how the predictable fluctuations in loan demand and deposit flows can cause changing liquidity needs and how a bank might anticipate such changes.

Explanation / Answer

The ability of a financial institution to meet demand for deposit withdrawals and other cash outflows is a visible indicator of its viability. If a credit union cannot meet depositor withdrawal requirements, general creditor expenses, or if it is forced to significantly limit new lending, a lack of member confidence can develop.

The level of liquidity which is maintained must at a minimum meet regulatory requirements. Liquidity must also be sufficient to satisfy demand for cash withdrawals, financing commitments for approved loans, and routine operating cash outflows. Too much liquidity (excess liquidity), on the other hand, can be an inefficient use of funds, and can restrict the profitability of the credit union.

Liquid assets should be managed with due regard to principal safety, yield volatility, and, where liquid assets bear risk, investment diversification. Credit unions should have access to supplemental lines of credit or segregated liquidity pools to satisfy liquidity requirements.

Policy

It is recommended that the credit union adopt a liquidity policy that addresses:

Liquidity Management Philosophy

Adopting a liquidity management philosophy is an important first step in drafting liquidity policy. The philosophy sets out the broad goals and objectives of the credit union with regards to liquidity, as established by the board of directors. This philosophy governs all liquidity policy constraints and helps address new situations where policy does not yet exist.

While goals and objectives will differ depending upon the circumstances and environment of the credit union, important principles of liquidity management should always address the following principles:

Operational Procedures

The following procedures can assist management to monitor cash flow needs, to monitor compliance with regulatory and policy liquidity needs, and to address liquidity shortages or excesses.

Monitoring Liquidity Needs

The credit union's liquidity needs should be reviewed on a periodic basis. For most credit unions, this will mean at least on a weekly basis. This review should encompass a detailed forecast of imminent liquidity requirements and a broad projection of cash needs for the next three month period.

Summary measurements of liquidity needs should be prepared for board review at each board meeting, in addition to the risk measurements discussed in Section 8400.

To determine immediate cash flow needs, a cash flow statement can be used to develop projections for the next three months. Periodic (weekly or monthly) cash flow projections can predict whether excess or deficient liquidity levels will be experienced by the credit union in the near future. If deficiencies are below operational levels, management will have to take action to correct these levels.

Liquidity Shortages

Whenever deficient liquidity levels are discovered, management must prepare marketing and financial strategies to align liquidity levels within desired targets, or take defensive actions.

Defense actions to protect the liquidity position of a credit union would normally include:

It should be recognized that the above noted defense actions are listed in order of most attractive to least attractive option. Curtailment of lending activity is considered least desirable because of the negative effect on member confidence, however, certain restrictions on lending may become a necessary trade-off in a liquidity crisis. Early reaction, in terms of moderate or temporary curtailment of lending, will often overcome the need for drastic measures at some later stage.

Alternative liquidity defense strategies such as an available overdraft facility and an approved line of credit facility with a league or chartered bank are recommended sound business and financial practices. The use of an overdraft facility permits a credit union to maximize the value of its float without jeopardizing the clearance of its negotiable instruments. One example of an aggressive cash management strategy would be to make the greatest possible use of short term call deposits in the money market while permitting the current account to be in occasional overdraft position, in order to maximize earnings.

Excess Liquidity

Where a credit union has significant liquidity in excess of statutory requirements due to unanticipated net cash inflow, management should examine options to reduce liquidity to an appropriate level. High levels of liquidity generally have an unfavourable effect on profitability, as the rate of return earned on short-term investments is usually not as high as the yield on loans, and cash held in the credit union earns no interest. In order to reduce liquidity which is in excess of operational requirements, management should ensure it has exhausted all credit granting opportunities, without compromising on credit quality. Alternatively, the credit union should undertake membership drives to expand loan demand.

Where the promotion of credit does not fully utilize excess liquidity, interim investment of funds should generally be made in short-term investments, so that conversion to new loans may readily occur. During an economic downturn or in situations where aging member demographics are difficult to reverse, board and management may determine that a portion of excess liquidity is likely to persist for longer than the current fiscal period. In such situations, management should look for safe investments with terms in excess of one year that would generate higher yields.

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