2026

MODULE 4
LIQUIDITY AND LIQUIDITY
MANAGEMENT

COMMERCIAL BANK MANAGEMENT

Liquidity risk

Liquidity management strategies

KEY
TOPICS IN
Measuring liquidity risk exposure
THIS
MODULE
Estimating liquidity needs

Legal Reserves and Money Position

Management
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Liquidity Risk
 Liability-side liquidity risk
The risk that a sudden surge in liability withdrawals may leave an FI in
a position of having to liquidate assets in a very short period of time and
at low prices.
 Asset-side liquidity risk
The risk that demand for liquidity immediately from off-balance-sheet
loan commitments force FI to liquidate assets in a very short period of
time and at low prices or borrowing funds costly.

Net Deposit Drain

 Net Deposit Drain is defined as the amount by which cash withdrawals exceed
deposit additions over a specific period, representing a net cash outflow for the
institution.
• Net Positive Drain (Contraction): Expected level of withdrawals is higher
than new additions. The liability side of the balance sheet contracts because
existing cash flows are insufficient to offset withdrawals.
• Net Negative Drain (Growth): New deposit additions more than offset
withdrawals (net cash inflows). The institution is expanding in size

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Liquidity Management Strategies

 Asset Liquidity Management (Asset Conversion Strategy)
 Definition: FI stores liquidity in the form of liquid assets.
 Characteristics of Liquid Assets: a ready market, a reasonably stable price, and
being reversible.
 Popular Liquid Instruments: Treasury bills, federal funds loans to other
institutions, repurchase agreements (RPs), municipal bonds, and federal agency
securities.
 What are the Advantages and Disadvantages of this strategy?

Liquidity Management Strategies

 Borrowed Liquidity (Liability) Management Strategy
 This strategy, often called purchased liquidity, involves borrowing immediately
spendable funds from the money market to cover all anticipated demands for
liquidity.
 Key Borrowing Options: Federal funds borrowings, Repurchase agreements,
issuing CDs ($100,000 +), Eurocurrency deposits, the central bank's discount
window.
 What are the Advantages and Disadvantages of this strategy?

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Liquidity Management Strategies

Balanced Liquidity management Strategies
 It combines both asset conversion (stored liquidity) and borrowed liquidity
(liability management) to meet its liquidity demands.
 Expected vs Unexpected liquidity Needs
• Expected liquidity Demands are met by storing liquidity in assets.
• Unexpected Needs by advanced arrangements for lines of credit from
potential suppliers of funds.
 Time-Based Allocation
• Short-term needs: near-term borrowings in the money market
• Long-term liquidity needs: short- and medium-term assets

Measuring a Bank’s Liquidity Risk Exposure

 Financing Gap and Financing Requirement
 Financing gap = Average loans − Average deposits
 Financing Requirement (borrowed funds) = Financing Gap + Liquid Assets
 Risk Indicator: A widening financing gap serves as an early warning sign of
potential liquidity stress

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Measuring a Bank’s Liquidity Risk Exposure

 Sources and Uses of Liquidity
 Sources of Liquidity: These include total cash-type assets, the maximum limit of
borrowed funds (internal guidelines), and excess cash reserves held at the Federal
Reserve.
 Uses of Liquidity: These represent the borrowed funds already utilized and any
outstanding loans from the Federal Reserve's discount window.
 Total Net Liquidity: The difference between total sources and total uses provides
the, allowing managers to track and adjust their cash positions daily.

Measuring a Bank’s Liquidity Risk Exposure

 Peer Group Ratio Comparisons
 Loans to Deposits: A high ratio indicates a heavy reliance on volatile wholesale
markets rather than stable core deposits.
 Borrowed Funds to Total Assets: Measures the proportion of the DI's funding
coming from short-term money markets.
 Commitments to Lend to Assets: A high ratio suggests significant potential
asset-side liquidity risk if customers decide to "take down" their credit lines

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Measuring a Bank’s Liquidity Risk Exposure

 Peer Group Ratio Comparisons
 Asset-Side Indicators (Stored  Liability and Off-Balance Sheet Indicators.
Liquidity)
• Hot money ratio: Compares short-term money
• Cash position indicator: The ratio of market assets to volatile "hot money" liabilities.
cash and deposits due from other
institutions to total assets. • Core deposit ratio: Core deposits divided by
total assets.
• Liquid securities indicator: The ratio of
U.S. government securities to total • Loan commitments ratio: Unused loan
assets. Since these are highly marketable. commitments divided by total assets.
• Net federal funds and repurchase
agreements position: This measures the
comparative importance of overnight
loans relative to overnight borrowings.
• Capacity ratio: Net loans and leases
divided by total assets.

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Measuring a Bank’s Liquidity Risk Exposure

 The Liquidity Index
 Definition: The Liquidity Index, developed by Jim Pierce at the Federal Reserve, measures
the potential losses an FI could suffer from a sudden or fire-sale disposal of assets compared to
the amount it would receive at fair market value established under normal market conditions.
 Formula:

 Where:
• Fire-sale price (Pi): The price received for an asset that must be liquidated immediately.
• Fair market price (Pi∗): The price the FI would receive if it had a longer horizon to negotiate
a sale, such as through a careful bidding process
• wi : The percentage of each asset in the FI’s portfolio.
• Pi/Pi∗ : The ratio of the fire-sale price to the fair market price for asset I

 Interpretation: Index I between 0 and 1, a lower index value indicates higher liquidity risk

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Modern Regulatory Indicators

 Liquidity Coverage Ratio (LCR): Ensures the firm holds enough High-Quality Liquid Assets (HQLA) to
survive an acute stress scenario lasting 30 days.

 Stock of High-Quality Liquid Assets  Total Net Cash Outflows

o Level 1 Assets (cash, central bank reserves, and
Total net cash outflows over the next 30 calendar days
certain sovereign debt) have no cap and are not
= Outflows – Min (inflows; 75% of outflows)
subject to a haircut.
o Level 2A Assets (government-guaranteed
mortgage-backed securities and corporate bonds
rated at least AA) are subject to a 15% haircut
o Level 2B Assets (non-government-guaranteed
residential mortgage-backed securities, lower-
rated corporate bonds, and blue-chip equities)
are subject to a 50% haircut.
o Limits: Level 2 assets <= 40% the total HQLA
stock, and Level 2B assets specifically are
capped at 15%.
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Modern Regulatory Indicators

 Liquidity Coverage Ratio (LCR):

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Modern Regulatory
Indicators

Liquidity Coverage Ratio (LCR):

Example: OneBank has the following
balance sheet (in millions of dollars).
Cash inflows over the next 30 days
from the bank’s performing assets are
$5 million.

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Modern Regulatory Indicators

 Net Stable Funding Ratio (NSFR) Evaluates
liquidity over a one-year horizon to ensure that long-
term assets are funded with reliable, stable sources of
financing.

 Available Stable Funding (ASF)  Required Stable Funding (RSF)

o 100% Factor: Total regulatory capital (Tier 1 and o 0% Factor: Cash and all central bank reserves
Tier 2), preferred stock with a maturity of one year
or greater, and other liabilities with effective o 5% Factor: Unencumbered Level 1 high-quality
maturities of one year or greater. liquid assets (HQLA)
o 95% Factor: "Stable" retail and small business o 15% Factor: Unencumbered Level 2A assets
deposits with residual maturities of less than one o 50% Factor: Unencumbered Level 2B assets, HQLA
year encumbered for six months to one year, and loans to
o 90% Factor: "Less stable" retail and small financial institutions with maturities under one year
business deposits o 65% Factor: Unencumbered residential mortgages
o 50% Factor: Unsecured wholesale funding and other unencumbered loans with a maturity of one
provided by nonfinancial corporates, sovereigns, year or more (subject to specific risk weights)
and central banks o 85% Factor: Other performing loans with maturities
o 0% Factor: All other liabilities and equity of one year or more and physical traded commodities
categories not specified above like gold
o 100% Factor: All other assets, including premises
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Modern Regulatory Indicators

 Net Stable Funding Ratio
(NSFR):
• Example: Calculation of the Net
Stable Funding Ratio for OneBank

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Market Signals
 Public Confidence: Evidence that the public or other institutions believe the firm
is losing money or may be unable to pay its obligations
 Stock Price Behavior: A significant drop in the corporation's stock price
 Risk Premiums on Borrowings: higher interest rates on its CDs or other
borrowings compared to peer institutions of similar size and location.
 Loss Sales of Assets: Evidence of asset sell-offs, especially a frequent occurrence.
 Meeting Credit Commitments: unable to honor all potentially profitable loan
requests due to a lack of funds is a clear indicator of a liquidity shortage.
 Borrowings from the Central Bank: Frequent or large-volume borrowing from
the central bank.

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The Sources and Uses of Funds

Approach
The Structure of Funds Approach
Estimating
Liquidity Indicator Approach
Liquidity
Needs Modern Regulatory Indicators

Market Signals

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Estimating Liquidity Needs

 Demand for and Supply of Liquidity
Demands for Liquidity
Supplies of Liquidity (Inflows)
(Outflows)
A financial • Incoming customer deposits
• Customer deposit
firm’s Net • Revenues from nondeposit
withdrawals.
services.
liquidity = • Customer loan repayments.
- • Credit requests.
position at • Repayment of previous
time t (Lt) • Sales of assets.
borrowings.
• Borrowings from the money
• Operating expenses and taxes
market.
• Dividend payments

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Estimating Liquidity Needs

 The Sources and Uses of Funds Approach
 Liquidity gap is the size of the difference between Sources and Uses of fund.
Estimated change in Estimated change in
𝐋𝐢𝐪𝐮𝐢𝐝𝐢𝐭𝐲 𝐠𝐚𝐩 = −
deposits loans
 The Three-Component Forecasting Method
• Trend Component: A long-term growth rate
• Seasonal Component: Behavior in any given week or month compared to the
most recent year-end.
• Cyclical Component: Positive or negative deviations from the trend and seasonal
components

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Estimating Liquidity Needs

 The Sources and Uses of Funds Approach
Table 4.
Forecasting Deposits and Loans
(in million of dollars)

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Estimating Liquidity Needs

 The Sources and Uses of Funds Approach
Table 4. Forecasting Liquidity Deficits and Surpluses (in million of dollars)

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The Structure of Funds Approach

 Step 1: Classification of Funds
o "Hot money" liabilities (Volatile liabilities)
o Vulnerable funds
o Stable funds (Core deposits)
 Step 2: Setting Liquidity Reserves, as common rule of thumb:
o 95% reserve against hot money.
o 30% reserve against vulnerable funds.
o 15% or less against stable funds
o Incorporating Loan Liquidity Needs: 100% reserve against the difference
between the maximum potential loans and the actual loans currently outstanding
 Step 3: Combining both loan and deposit liquidity requirements.
o Total Liquidity Requirement = (Reserves for Hot Money + Vulnerable + Stable
funds) + (Potential Loans – Actual Loans)

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The Structure of
Funds Approach
 Example:

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The Structure of Funds Approach

 Probability-Weighted method of measuring the liquidity requirement
 Assigning probabilities to different liquidity outcomes
o Worst-case: Minimum deposit growth and maximum loan demand.
o Best-case: Maximum deposit growth and minimum loan demand
o Most likely: The outcome with the highest probability
 The Expected Liquidity Requirement is then calculated by multiplying the
estimated surplus or deficit of each outcome by its assigned probability

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 Probability-Weighted method of measuring the

The Structure of liquidity requirement

Funds Approach  Example

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Legal Reserves (Required Reserves)

 Legal reserves are assets that government regulations require a financial

institution to hold in support of its deposits. It includes vault cash and
deposits at the central bank.
 Money Position Management
• Any holdings in excess of the legal requirement represent an opportunity
cost.
• Falling below the required level can result in significant monetary penalties
from the central bank

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Legal Reserves (Required Reserves)

 Reserve Computation Period: A two-week period during which the daily average
amount of reservable deposits is calculated.
 Reserve Maintenance Period: A subsequent 14-day period during which the
institution must hold the required average daily reserve balance (minus its vault
cash) at the Federal Reserve.
 Reserve Requirements: It depends upon the volume and mix of each institution’s
deposits and on the particular time period. Calculation:
Total Required Legal Reserves =
= (Reserve requirement on transaction deposits × Daily average amount of net
transaction deposits over the computation period)
+ (Reserve requirement on nontransaction reservable liabilities × Daily average
amount of nontransaction reservable liabilities over the computation period)

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Legal Reserves (Required Reserves

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Legal
Reserves
(Required
Reserves)

Factors influencing
the Money position

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Factors in  Immediacy of Need

 Duration of Need
Choosing among  Access to the Market
the Different  Relative Costs and Risks
Sources of  Interest Rate Outlook
Reserves  Central Bank Monetary Policy
 Rules and Regulations

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