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Linear
for
ProgrammingModel
Commercial
Bank
Liquidity
Management
Introduction
The primarypurposeof commercialbankliquidity
managementis to supportotherbankingfunctionsby
maintainingreservesto meet unanticipateddeposit
withdrawalsand an inventoryof near cash funds to
satisfy potentialcreditdemands.Becauseof the substantial volume and the frequentturnoverof assets
and liabilities, liquidity managementrequiresclose
attentionto money marketportfoliomanagementas
well as to the supportof depositand creditactivities.
The numerousconstraintson such activity suggest
that liquiditymanagementmay best be accomplished
using mathematicalprogramming.
This paperdescribesthe developmentof a practical
and usable mathematicalprogrammingmodel for liquiditymanagementin a mediumto largecommercial
bank. Although there are differencesin the models,
the motivation for the application discussed here
comes from Komar [7].
The bank has total assets of approximately$800
million and an investmentportfolio (securitiesand
1979 FinancialManagementAssociation
41
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42
FINANCIALMANAGEMENT/AUTUMN1979
the vast amountof informationthat confrontsthe liquidity manager daily. Yields on alternativeliquid
assets and liabilities,cash flows, and liquidityneeds
are analyzedsystematicallyin the model.
Behavioral Implications
Liquidity management involves a number of
specialistsmaking independentdecisions. The function may actuallybe performedby severalindividuals;
one, for example, concentrating solely on CDs,
anotherconcernedwith Treasurysecurities,and still
anothermanagingthe municipalportfolio.Typically,
a single individualwho is responsiblefor the overall
performanceof the liquidity managementfunction
coordinatesthese separatefunctions.
A model designedto improvethe efficiencyof liquidity managementmust be able to accommodate
such an environment.Almost by definition,a mathematical programmingmodel focuses on the coordinationof these activitiesvia an interrelatedset of objectivesandconstraints.In this particularapplication,
use of the modelnot only improvedcoordinationand
cooperationamong the managers,but also, for the
first time, made availablequantitativeguidelinesand
objectives.
Technical Implications
To implement the mathematical programming
model for liquiditymanagement,it was necessarynot
only to create a computer-basedmodel, but also to
consider the interface between the model and the
bank's accountingrecordsand data bases.
First came analysisof the relativemerits of batch
processingand time sharing.As will be demonstrated
later, the aggregationof variablesfavors the use of
time sharing.Furthermore,the necessityfor speedto
make decisionsin responseto changingyield structures,securityavailability,and unexpectedcash flows
requiresthat the model be readily accessibleto the
user, withoutdelays in the conversionof raw data to
usable results. A conversational, time sharing
programwas thereforedevelopedto facilitatedata entry andto processquicklythe dataandsolutionoutput
in usable form. (A partialexampleof the program's
conversationalformat is includedas an Appendix.)
To expedite the solution process, automation of
data entry, processing, and retrieval is important.
Therewas no obstaclehere,becausethe bankalready
had highly-sophisticatedinvestment portfolio data
processingprocedures.Withoutthe abilityto interface
with bank accountingrecordsand data bases, a li-
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43
FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT
quidity management model based upon a management science approach would be very difficult to implement.
The Model
The liquidity management model requires input
information reflecting money and capital market
supply and demand conditions (i.e., yields, maturity,
and availability of money and capital market instruments), tax rates, anticipated credit demands and
deposit withdrawals, and other factors affecting commercial bank liquidity. The output provided by the
model indicates the amount to be held of each type of
liquid asset and liability and the highest net earnings
(lowest net cost) consistent with the constraints.
The liquidity variables are assumed to be continuous. Given the size of the bank's investment portfolio, this assumption appears justified and is consistent with the bank's pre-model experience. To insure
that the continuity assumption is not compromised,
constraints are included in the model reflecting feasible attainment levels for the liquidity variables.
The relationships among variables are assumed to
be linear. While at the extreme, some of the relationships are nonlinear or, more likely, piecewise linear
with step function risk premium yield structures, the
model includes constraints which are designed to
preserve the linearity assumption. Specifically, upper
and lower limits on asset acquisition or sale are formulated so that the viability of the assumed constant
risk premium yield structures is maintained.
Together, the continuity and linearity assumptions
allow the use of linear programming.
The Variables
The following asset categories are considered in the
model as decision variables: 1) Treasury securities, 2)
Agency securities, 3) Municipal securities, 4) Project
notes, 5) Federal funds, 6) Certificates of Deposit, 7)
Repurchase Agreements (and reverse repurchase
agreements), and 8) Federal Reserve Discount Window borrowings. Other variables such as bankers'
acceptances and Eurodollars can easily be incorporated into the model if desired. Each of the
variables is defined appropriately as the purchase or
sale of a liquid asset (say, a Treasury bill) or as the
issuance of a liquidity liability (a certificate of
deposit), depending on whether the instrument is seen
as a source or use of funds. In most cases, the
variables are further delineated by maturity, type of
issue, and other characteristics. Exhibits 1 and 2 present the variables categorized as sources or uses of
funds.
* ., m,)
(=1
x2j(j = . , m2)
1 . * m3)
X3j (=
m4)
X4j (j= , ...
Xsj0= 1 * * * m,)
x6j (j= 1, . , m6)
xlj
Instrument
Type
Treasury Securities
Agency Securities
Asset
Asset
Project Notes
CD- Bank
Asset
MunicipalSecurities
Asset
Asset
ReverseRepurchase
Agreements
Asset
X7
Asset
1, . . , ni)
1, ..., n)
, n3)
1,
1, . . , n4)
1, .., n)
1, . .., n6)
Y7
(k= , .. ., n8)
1 .. , n9)
Yio
y8k
y9k (k=
Instrument
Treasury Securities
Agency Securities
Municipal Securities
Project Notes
CD-Bank
Repurchase Agreements
Federal Funds Bought
CD - Public Money
CD - Money Market
Discount Window
Borrowings
Type
Asset
Asset
Asset
Asset
Asset
Liability
Liability
Liability
Liability
Liability
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44
FINANCIALMANAGEMENT/AUTUMN1979
Z. bijxj-- 2
ij
i k
b,yikY.
(1)
Y5k
<
Tysk
(2)
(3)
k = 1, ...,.
n5.
(6)
2It should be noted that yield forgone from assets sold is associated
with a decision-making criterion, as are the yields associated with
issuance of liquidity liabilities or the acquisition of liquid assets. To
calculate the actual, financial accounting value of the objective function (profit or loss), it is necessary to add to the objective function
the revenues from assets held in the portfolio prior to the solution of
the model. The program does this automatically.
3For instance, some state chartered banks that are not members of
the Federal Reserve System may hold some of their reserves in the
form of liquid assets. An institutional constraint would apply to this
situation.
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45
FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT
zy3k
2y4k
2Y8k
Ty3k
2
-
Ty4k,
(7)
2 aij xij +
1J
ii
2 aik
ii J
(8)
ZX4j -
J
.X4j -
( )
Lik,
(11)
aijork) =
(10)
2Y4k + Ty4k
P. (12)
In this illustration, project notes are limited to P percent of the total tax-exempt portfolio. Of course,
many other variations of this basic formulation are
possible.
Portfolio composition constraints allow recognition
5For example, consider agk the coefficient associated with the kth
CD-Money Market instrument issued. When (CDs - Money
Market) are issued, cash available is slightly reduced on the CD
because of reserve requirements. ThUs, agk = 1-0- reserve requirement (%) +0 < 1, where the exact value of the coefficient depends
on the actual reserve requirement.
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FINANCIALMANAGEMENT/AUTUMN1979
46
(13)
assets may achieve. Constraintsmay also be formulatedthat providean absolutelimit (as opposedto
an averagelimit) for all assets in a given category.It
shouldbe apparentfrom the formulationof Equation
(13) that a relationshipexists betweenthe maturity
constraintsand the term structureof interest rates.
Givensufficientdetailin the definitionof the maturity
rangesfor the liquidityvariables,it is possibleto accommodatethe manager'sviewsof futureinterestrate
levels relativeto currentlevels. By manipulatingthe
right-hand-sidevalues, the manager may either
lengthenor shortenthe averagematurityor absolute
maturityof his portfolio.This allows him to injecta
furtherelementof his risk/returnpreferenceinto the
frameworkof the model.
4. Securities' Gain (Loss) Constraint. The
securities'gain (loss) constraintis one of the general
form:
Zliyi < R,
(14)
Modifications
Many banks are unfamiliar with mathematical
programmingtechniques and management science
methods. To reduce the complexity of the initial
applicationof linearprogramming(therebyreducing
any institutional reluctance that might prevent
successfulimplementation),a modifiedversionof the
model may be necessary.
Aggregation of Variables
The model we have describedconsists of several
hundred variables and a similar number of constraints. For a model of more manageableproportions, the bank is now using an aggregatedversion.
For example, instead of separatelyconsideringall
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47
FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT
in practice,aremuchworsethannon-optimalones [7].
Furthermore,substantialempiricalevidence[4, 9, 10,
11, 12] suggeststhat money and capital marketsare
"efficient,"and that interestrate changescannot be
forecastwith the precisionrequiredby a short-term
liquiditymanagementmodel.
The importanceof intertemporalconsiderationsis
recognized by including in the model a series of
maturity constraints. These constraints permit
managersto entertheir subjectiveassessmentsof the
futuredirectionof interestrates.Thus,the maturityof
any portionor all of the investmentportfoliocan be
lengthenedor shortenedto be consistentwith future
expectationsregardingthe term structureof interest
rates.
Furthermore,because of the ease with which this
model may be accessed,differentaverageand/or absolute maturity limit assumptions can be readily
tested. Such simulationsenable the user to capture
some of the powerof multiperiodmodelswithouttheir
disadvantages.If the model is run frequently,the
penalties for this somewhatmyopic approachto liquidity managementare likely to be small, because
adjustmentsreflectingcurrentmarketconditionsand
anticipatedchangesin marketdirectioncan be made
quickly.6
Implementation
At this particularbank,liquiditymanagementis the
responsibilityof the InvestmentManagementDivision. This division includes an investmentmanager
who determinesportfolio composition and trading
strategiesfor long-termsecurities,a money manager
who determinesliquidity managementpolicies, and
analysts assigned to each of them. The division is
coordinatedby a seniorvice presidentfor investments
and money managementwho reportsdirectlyto the
chief operatingofficer of the bank.
At least once a week, the liquidity management
staff meets to discuss and coordinate plans and
policiesfor the comingweek,the next fourweeks,and
the currentquarter.Bankwideplans and policies are
determined quarterly at the asset/liability senior
managementcommittee meeting. These plans and
policiesare designedto guidethe operationsof the investmentsdivisionas well as the otherdivisionsof the
bank.
At the beginningof eachweek,the seniorvice president for investments,the investmentmanager,andthe
money manager meet to review and revise, as ap'The authors would consider the framework presented in [1] to be an
appropriate extension without undue loss of simplicity.
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48
FINANCIALMANAGEMENT/AUTUMN1979
Conclusion
The benefitsof constructingandimplementingsuch
a model are not easily measured. Improved communicationand coordinationin managingliquidity
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FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT
and better education of the staff are not readily quantifiable. Nor, for that matter, can the profits generated
based upon decisions aided by the model be readily
compared to profits generated based upon the unaided
decisions of the staff. Independent, parallel performance cannot be measured because of the interaction
of the participants with the model prior to strategy
selection. Clearly, it is impossible for managers to
both participate in the process and to select a strategy,
unaided by the model, that would be comparable.
Also, comparison on the basis of an ex post simulation
of the model is not relevant because the managers'
decisions are influenced by model recommendations.
There are, however, indications besides its continued use that the introduction of the model has been
successful. Strategy selection sessions have become a
regular and important part of the liquidity management process. Analysts have been able to assume
responsibility for decision-making much more rapidly
since the model's introduction. Finally, the increase in
emphasis on profitability has caused the Investment
Management Division to be classified in the bank's accounting system as a profit center rather than simply
as a source of funds to support other banking functions.
References
1. Parvis Aghili, Robert-H. Cramer, and Howard E.
Thompson,"Small Bank BalanceSheet Management:
ApplyingTwo-Stage ProgrammingModels,"Journal
of Banking Research (Winter 1975), pp. 246-256.
49
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Appendix*
THIS PORTTION OF THE PROGRAI UTILIZES
INFORMATION FROM BOTH THE
USER AND DATA FILES 'ND COMPUTES THE NECESSARY INPUT DATA ON
MANAGEiENT CONSTRAINTS PREPARATORY TO RUNNING THE LIQUIDITY
MANAGEMENT LINEAR PROGRAMIMING MODEL.
CASH-FLOW
CONSTRAINT.
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
LIQUIDITY
CAPABILITY-SIZE
CONSTRAINT.
THE LIQUIDITY
PORTFOLIO SIZE CONJSTFAINT
CAPABILITY-INVESTMENT
WILL NOT. BE COMiPUTED.
THE INVESTIMENT PORTFOLIO (TREASURY,
AGENCY.
'S,
UNIlCIPAL.,
F.H.A.
PROJECT NOTES.
CD'S,
AND COMMERCIAL PAPER)
iiUST NOT BE GREATER THAN' P PERCENT OF LOANS PLUS INVESTMENTS
( iNVESTMiENTS INCLUDE ALL ASSETS EXCEPT FED FUNJDS SOLD AND CASHAN D- DUE- FROMI-EANKSS) .
I?HAT IS
?.4
P,
MUNICIPAL
PORTFOLIO
SIZE
CONSTRAINT.
*Some responses have been deleted to protect the identity of the bank.
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