2.

0 Bank Management There has always been a dilemma for bank management in reconciling the conflicting goals of solvency and liquidity on the one hand and profitability on the other. At the expense of bank safety, expected profitability often can be increased when banks take on more credit risk, Interest rate risk, or liquidity risk. However, bank safety is concerned about a banks ability to survive as a going concern-staying in business. Thus, banks are more likely to fail at the lower level of bank safety. For a bank to survive, bank managers must, bank managers must balance the competing demand of three constituencies: shareholders, depositors, and bank regulators. If bank managers do not generate adequate profits, shareholders may become dissatisfied with management and sell their stock, driving the banks stock price lower. If bank managers take on too much of risk, bank depositors (especially uninsured one) may become concerned about the safety of their deposits and they remove them, creating a liquidity crisis for the bank. On the other hand, bank regulators try to ensure that bank managers are prudent in their trade-off decisions between profitability and risk or safety. Bank regulators may intervene in the management of bank or, at the extreme, revoke the banks charter if they believe that the actions of managers are imprudent. Taking very little risk may be able to ensure the banks safety, but the bank would not be making much of the profit.

2.1. Liquidity Management Liquidity management is the management of a banks ability to accommodate deposits withdrawals and loan requests, and pay off other liabilities as they become due. In other words, the management of the banks liquidity risk. Lower liquidity risk is associated with higher bank safety and generally lower bank profits. If a bank can obtain enough funds, either by increasing liabilities or by converting assets, in a promptly manner and at a reasonable cost, it is considered as have an adequate liquidity. Liquidity is crucial in the compensation of both expected and unexpected balance sheet fluctuations and to provide funds for growth of banks. The price of liquidity is a function of market conditions and market perception of the risks, both interest rate and credit risks, reflected in the banks balance sheet and off-balance sheet activities. Additionally, market perception of management and strategic direction can be critical to the price of liquidity. To the extent that liquidity needs are met through holdings of high quality short-term assets, the price of liquidity is the income sacrificed by not holding
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longer term and/or lower quality assets. If liquidity needs are not met through liquid assets holdings, a bank may be forced to restructure or acquire additional liabilities under adverse market conditions. The determination of the adequacy of a banks liquidity position depends upon an analysis of its historical funding requirements, current liquidity position, anticipated future funding needs, present and anticipated asset quality, present and future earnings capacity, present and planned capital position and so on. Economic and money market trends are highly monitored as it is a key to liquidity planning. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. Once liquidity needs have been determined, management must decide how to meet them through asset management, liability management, or a combination of both.

2.2. Asset Management A bank needs liquid assets to accommodate deposits withdrawals, pay other liabilities as they become due, and accommodate loan requests. Such needs may be met by manipulating the banks asset structure through the sale or planned runoff of a reserve of readily marketable assets. The holding of liquid assets for liquidity purposes is less attractive because as it lowers the profitability. Long-term maturity securities investments allow banks to earn higher interest on loans but it is not easily converted into cash assets, and if converted the conversion costs can be quite high due to the adverse balance sheet fluctuations. As many banks (primarily the smaller ones) tend to have little influence over the size of their own liabilities, liquid assets enable a bank to provide funds to satisfy increased loan demand. Bank which rely solely on asset management concentrate on adjusting the price and availability of credit and the level of liquid assets held in response to a change in customer assets and liability preferences. The following general conclusions can be drawn from the examination on assets held by the commercial banks: (1) investment securities are more liquid than bank loans because of their superior marketability, and (2) short-term investments are more liquid than long term investments because of the smaller price risk. Asset management classifies bank assets to four basic categories: primary reserves, secondary reserves, bank loans, and investments for income and tax shields.

i.

Primary Reserves In the balance sheet, the cash assets of a firm which are include under the heading cash balances due from depository institutions are considered to be the banks primary reserves to meet liquidity requirements. Vault cash and deposits held at other depository institutions and at Federal Reserve banks are some of the types of assets included. Upon liquidity demand, the primary reserves are immediately available at no cost to the bank. Cash items in process of collection, while not immediate cash, are being converted into cash on an ongoing basis. Bank managers tend to minimize the amount of primary reserves they hold as it does not earn any interest.

ii.

Secondary Reserves Secondary reserves are also held in help to meet depositor withdrawal demands and other liabilities as they come due. They are made up of short-term securities/assets held by banks that can be quickly converted into cash at little cost to the banks. Treasury bills, Federal agency securities, repurchase agreements, bankers acceptance, negotiable certificates of deposit, federal funds, and commercial papers (that will mature in less than a year) are literally considered a banks secondary reserves. Treasury bills and short-term government agency securities made up most of it. Secondary reserves are preferred over primary reserves because at least interest can be earned. However, because the securities that compose secondary reserves are highly marketable and have low default risk, they typically have yields below the yields of the loans and other investment securities held by the bank.

iii.

Bank Loans Under this category, banks accept deposits from savers and, in turn, make loans to businesses and individuals. It is generally less liquid and has higher risks of default than other banks assets. As a consequence, bank loans offer higher potential profit than do other securities. Bank concentrate on meeting loan demand by individuals and businesses after setting primary reserves and secondary reserves targets. Higher interest rates can be charged to riskier borrowers, but such customers also are more likely to default on their loans. Bank managers must trade off the size of their loan portfolios against the amount of credit risk they are willing to assume. The acceptance of higher credit risk also increases the likelihood of insolvency.
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iv.

Investments After primary reserve and secondary reserve targets have been set, loan demand met, and bank fixed asset decisions have been made, remaining funds are invested in the open-market instruments. The primary function of the investment portfolio is to provide income and tax advantages to the bank rather than liquidity. Open-market instruments are typically longer-term securities that are less marketable and have higher default risk than the short-term securities held as secondary reserves. These investments therefore offer higher potential profitability to the bank. Included would be U.S. government notes and bonds, state and local government debt securities, long-term Treasury securities, municipal bonds and other securities. Municipal bonds are preferred over corporate bonds as they offer higher after-tax yield.

v.

The Asset Mix The dilemma between bank profitability and liquidity arise once again when deciding on the proportion of liquid assets that a bank should hold. The greater the proportion of primary and secondary reserves the bank holds, the greater the liquidity of its portfolio in the expense of lower interest returns. Thus, bank management came up with the bank strategy of holding the minimum amounts of primary and secondary reserves in consistent with the bank safety. At a minimum, banks are required to hold enough primary reserves to satisfy reserve requirements. In addition, banks usually hold enough additional primary and secondary reserves. Secondary reserves allow banks to earn some interest income while still meeting their liquidity needs. The stability of a banks deposit structure and the potential for rapid expansion in banks loan portfolio determine the amount of liquid assets bank should hold. If deposit accounts are composed primarily of small stable accounts, a relatively low allowance for liquidity is necessary. Besides reserve requirements, it is closely related to deposit variability, other sources of liquidity, loan commitments outstanding, and the risk posture of the banks management. Deposit variability is often determined by examining the past behavior, particularly in regard to deposit inflows and outflow. Deposit variability also depends on the type of account and bank customers. For example, demand deposits are more variable than time deposits. Lastly, management must consider

the current and expected ratings by regulatory and rating agencies when planning liquidity needs.

2.3. Liability Management Bank asset holdings were tailored to the deposit variability characteristics of their liabilities. Under liability management, however, banks take assets growth as a given and then adjust their liabilities as needed. This, when a bank needs additional funds for liquidity or any other purpose, it merely buys funds, such as federal funds purchased, and sale of securities under agreements to repurchase, in the money market. If short-term funding is not readily available in the marketplace, the bank may qualify for borrowings from the Federal Reserve Bank. Nowadays, the number of banks relying solely on manipulation of the asset structure to meet liquidity needs is declining.

i.

Liability Management Theory A banks liabilities can also help bank in maintaining a desired level of liquidity given the assumption that certain types of bank liabilities are very sensitive to the changes in interest rates. Thus, bank can immediately attract additional funds by raising the interest paid on these liabilities above the market rate. Conversely, by lowering the rate paid on these liabilities, a bank may allow funds to run off as the liabilities mature. These securities that are sensitive to interest rates and have markets large enough to accommodate the activities of the commercial banking system like negotiable certificates of deposit (CDs), repurchase agreements, Eurodollar borrowings, commercial papers, and federal funds would be included. If a bank needs cash to meet unexpected depositor withdrawals, it could immediately attract more liabilities by raising short-term interest rates being demanded in the marketplace. Or, if it is willing to pay that days interest rate, the bank could borrow federal funds from other banks that have excess reserves. Other bank liabilities, such as time and savings deposits, are generally less sensitive to immediate changes in interest rates, and changes in the posted offering rate will not result in notable inflows or outflows of funds. Thus, they receive less focus from a liability management standpoint. Longer-term debt and

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bank capital do not work well in terms of liquidity management because of the time it takes for debt and equity securities to be issued or sold. ii. Using Liability Management The liquidity gained by liability management enables the bank to use it to counteract deposit inflows and outflows so as to reduce variability. The purchase of new funds immediately offset the sudden and unexpected deposit outflows. Follow on; it may be used to meet increase in loan demand by banks customers. Customers will not be denied for loans anymore. As long as the expected marginal returns of the new loans exceed the expected marginal cost of funds, the bank can increase its income by acquiring the additional funds through liability management. Lastly, banks are able to participate in contingent commitments through the engagement in more off-balance-sheet activities. In conclusion, liability management is meant to supplement asset management in managing bank liquidity. Asset management remains as the primary source of liquidity for banks, particularly small banks. And if used properly, liability management will allows bank to reduce their secondary reserve holdings and invest these funds in higher-yield assets, such as loans or long-term municipal bonds. Smaller banks do not apply liability management as much as they do not have access to the discretionary funding sources in the money market. Liability management is not a universal remedy for bank liquidity problems. If banks incurred severe liquidity problems, bank managers may find it hard to even sell the negotiable CDs or commercial papers. Furthermore, in order for the bank to pay higher and higher interest rate to sell negotiable CDs, they must first find assets to invest in that will provide returns higher than the costs of funds. Otherwise, the company will make losses. From here, we can see that there are many times when banks are unable to attract or retain funds through liability management because of tight credit periods or because of uncertainty about the soundness of a particular bank. Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loans demand, misuse or improper implementation of liability management will lead to severe consequences.

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