After reading this article you will learn about:- 1. Introduction to Liquidity Management 2. Management of Liquidity and Cash by Banks 3. Steps 4. Principles.

Introduction to Liquidity Management:

Liquidity means an immediate capacity to meet one’s financial commitments. The degree of liquidity depends upon the relationship between a company’s cash assets plus those assets which can be quickly turned into cash, and the liabilities awaiting payments could be met immediately. The liquidity and the Investments are two corners opposite to each other.

If more earning is required more and more investment is to be made which may result into less degree of liquidity, which may result ,on account of not fulfilling the commitments, into penalties/high rate of interests or other type of losses.

In case and also in view of being fully capable of meeting any sort of financial commitments if sufficient liquidity is maintained and the funds are kept idle just to maintain the liquidity and are therefore not invested, this situation may also bring a stage of losses.


If the liquidity is kept at high level under the fear of not being capable of meeting financial requirements in time and the funds available are not invested is sure to count on losses for no returns on the funds available.

In case all the funds available are invested without care for even minimum requirement of liquidity/cash, in case of urgent need the financial commitments made may not meet the dead line and may also result in losses in form of penalty or very high rate of interest.

Management of Liquidity and Cash by Banks:

In case of banks investments are made out of the cash available with it, deposits received from public, companies, institutions and all other types of deposits both demand deposits and term deposits. Additionally a part of profit earned by the bank is also available. The main problem is a fact that every bank is bound by law that the deposits held with it are payable according to the obligation terms to depositors.

Demand deposits should always be kept ready by bank to be able to make immediate payment in case any demand arises. This very fact requires every bank to have sufficient liquidity to meet the contractual obligations as and when they arise without any delay.


Now the opposite or contrary picture also appears to be true because every bank wants to deploy maximum funds in advances and investments in hope of getting maximum possible returns. If all the funds available with any bank are lent or invested, there may be possibility that such funds are not recovered by the bank immediately and the bank is not able to meet its obligations towards its customers.

In order to retain the customer base the banks must adopt a liquidity/investment policy to be able to repay to depositors on demand. Incase bank deploys its maximum funds in loans/investment without caring for the requisite amount of liquidity to able to meet the immediate financial requirements particularly towards demand depositors, it may tarnish its image which can be a fatal event for any bank.

Yes if a bank under the fear of protecting its image to be able to meet all the demand requirements instantly keeps a large portion of its funds in liquid form either in cash with itself or deposits with the Central Bank i.e. RBI without earning sufficient returns or at low level of interest, naturally may face a situation of loss.

Investments by banks are its assets and demand and term deposits are liabilities.


Derived from above discussion it may be observed that an investment policy of a Bank should be a balanced approach for managing its assets and liabilities. In case of enhancing or increasing assets without taking into account the proportion of liabilities may bring more profit or income but the bank may likely fail in meeting its obligations.

In reverse position of quantum of liquidity is more than the required limit it may be a cause of losses. It may please be understood that Profitability and Liquidity stand against each other and are required to be managed in a planned manner.

Steps in Cash and Liquidity Management:

For cash and liquidity management by banks following steps are adopted:

1) Cash:

Cash is complete liquidity consisting of cash in hand held by the bank itself or deposited with Central Bank (RBI). The quantum of cash to be kept by a bank is regulated by statutory requirements known as SLR (Statutory liquidity Ratio) and CRR (Current Reserve Ratio). In addition to rules and regulations the practical experience of bankers also play a vital role in deciding the quantum of cash to be kept as cash in hand. Any idle cash kept earns no income.


It is therefore every bank adopts a system of complete cash management and investment management in order to measure and manage the liquidity needs. Measuring liquidity is a ticklish task and mostly gauged by Assets and Liability management system.

(2) Investments:

Investment by banks is largely regulated by specific guidelines as discussed above in portfolio management. Likewise cash management is also subject to SLR and CRR norms.

(3) Loans and Advances:

Commercial Banks function as financial intermediaries. They mobilise funds through various deposit schemes and a large portion of these funds are deployed as bank credit in various sectors of economy. In a way banks also function like trustee of savings and idle funds of the society.

The quality of the credit portfolio decides their efficiency of discharging their duty. In providing loans to different sectors of society is best suited method of managing excess cash by banks as this sector is more secure than making investment in capital market.

(4) Inter Relationship of Cash, Liquidity, Asset and Liability Management:


If the management of cash, liquidity and liabilities are put under one umbrella it would be seen as a process where all of them are inter linked and no single item can be managed separately without having look on other items.

Following brief description about these items may help to understand the position:

A. Asset and Liability Management:

It is a process of effectively managing a bank portfolio mix of assets, liabilities and when applicable off-balance sheet contracts. This process involves two primary financial risks, interest rate and foreign exchange, and directly relates to sound over all liquidity management.


B. Interest Rate Risk:

It is the process of the exposure of a bank’s financial condition to adverse movements in interest rates. Changes in interest rates can have significant impact on a banks earnings as well as the underlying economic value of a bank assets, liabilities and off balance sheet items.

C. Liquidity:

The ability to fund all contractual obligations of the bank. Notably lending and investment commitments and deposit withdrawals and liability maturities, in the normal course of business, that is the ability to fund increases in assets and meet obligations as they come due.


D. Liquidity Management:

It is an on-going process to ensure that cash needs can be met at reasonable cost in order for a bank to maintain the required level of reserves with RBI (CRR) and to meet expected and contingent cash needs. Required CRR/SLR with the RBI should not be considered to be a routine source of liquidity.

Good management information systems, analysis of net funding requirements under alternative scenarios, diversification of funding sources, and contingency planning are crucial elements of sound liquidity management.

E. Liquidity Risk:

It is a risk of loss to a bank resulting from its liability to meet its needs for cash or from inadequate liquidity levels, which must be covered by funds, at excess cost.

F. Net Funding Requirements:


The liquid assets necessary to fund a bank cash obligations and commitments going forward determined by performing a cash flow analysis, all cash inflows against all cash outflows, to identify potential net shortfalls.

Principles of Liquidity Management:

The Bank for International settlements’ Basel Committee on Banking Supervision in its document No. 69 February, 2000 has provided principles and details of key elements for effective management of liquidity.

Banks should formally adopt and implement these principles for use in overall liquidity management process:

A. Banks must develop a structure for liquidity management:

1. Each banks should have an agreed strategy for day-to-day liquidity management. This strategy should be communicated throughout the organization.

2. A Bank Governing board should approve the strategy and significant policies related to liquidity management. The governing board should also ensure that senior management of the bank takes the steps necessary to monitor and control liquidity risk. The Governing Board should be informed regularly of the liquidity situation of the bank and immediately if there are any material changes in the bank current or prospective liquidity position.

3. Each Bank should have a management structure in place to effectively execute the liquidity strategy. This structure should include the on-going involvement of members of senior management. Senior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are established to control and limit liquidity risk. Banks should set and regularly review limits on the size of their liquidity positions over particular time horizons.


4. Banks must have adequate information systems for measuring, monitoring, controlling and reporting liquidity risks. Reports should be provided on a timely basis to the banks governing board, senior management and central bank. (In case of India Reserve Bank of India)

B. Banks must measure and monitor net funding requirements:

1. Each bank should establish a process for the ongoing measurement and monitoring of net funding requirements.

2. Banks should analyze liquidity utilizing a variety of scenarios.

3. Banks should frequently review the assumptions utilized in managing liquidity to determine that they continue to be valid.

C. Banks should Manage market access:

Each banks should periodically review its efforts to establish and maintain relationships with liquidity holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets.

D. Banks should have contingency plans:

Banks should have contingency plans in place that address the strategy for handling liquidity crises and which include procedures for making up cash flow shortfalls in emergency situations.

E. Banks should manage their foreign currency Liabilities:


1. Each bank should have measurement, monitoring and control system for its liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually.

2. Subject to analysis undertaken, a bank should, where appropriate, set and regularly review limits on the size of its cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which the bank operates.

F. Each bank must have an adequate system for internal controls over its liquidity risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness or enhancements to internal controls are made.

G. Each bank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information about the bank in order to manage public perception of the organization and its soundness.