Liquidity management has always been an important matter for banks. In today’s world, many banks face increased liquidity strains, as competition for deposits forces them to look for alternative funding sources. At the same time, financial development has increased both the opportunities and risks in liquidity management. As a result, it is increasingly important that banks plan for their liquidity needs to ensure that they are using stable and low-cost methods to fund their operations. In a highly competitive world, only the efficient survive, and using high-cost funds puts a bank at a competitive disadvantage.

There are three basic approaches to liquidity management:

• Asset Management
• Liability Management
• Capital Management

Although they are listed separately, the three approaches are often used in combination to manage a bank’s liquidity position. Only the asset and liability approaches to liquidity management are covered in this course. These are shorter-term approaches to managing liquidity. The capital management approach is not discussed because it tends to be a longer-term approach to managing liquidity, but it is important to note that capital adequacy affects a bank’s access to other funding sources and thus has short-run liquidity implications as well.

Sensitivity to market risk (that is, changes in interest rates) can reduce a bank’s earnings and erode its capital. In light of these performance consequences, it is an important board responsibility to see that a bank’s market risk is effectively managed. The moral is not to become so focused on fixing one problem that you create another. The board should always consider the total needs of the bank when it is devising solutions to problems that the bank may encounter.

Few banks in recent history have failed because of uncontrolled market risk. (As used in this course, market risk is the risk to a bank's earnings and capital from changes in interest rates.) Even in well publicized instances, such as the 1995 failure of Barings Bank, one of the oldest banks in England, where market risk was linked directly to the bank's performance problems, it is usually the failure of a bank's operational controls that prevents the bank from identifying its market risk exposure until it is too late.

Although most banks will never fail outright, they can experience significant loss of earnings and capital due to uncontrolled market risk. Because of this, the federal banking agencies make it a board responsibility to ensure that a bank's market risk is effectively managed:

Establish and guide the bank’s tolerance for interest rate risk, including approving risk limits and other key policies, identifying lines of authority and responsibility for managing interest rate risk, and ensuring adequate resources are devoted to interest rate risk management…” May 23, 1996, Joint Policy Statement on Interest Rate Risk

This section of the course is devoted to liquidity and market risk management. It covers the basic tools banks use to control their liquidity and market risk exposure and offers matters to consider in a director's oversight of these risks.