Liquidity risk is the risk that a bank won’t be able to raise cash at a reasonable cost when it needs to do so. A bank’s need for liquidity depends on internal and external factors. If the bank plans and budgets well, it can anticipate many of its internal liquidity needs (such as funding loan growth, meeting depositor demands and paying operating expenses) and structure its balance sheet accordingly. If the bank knows its market, it can plan for many external events (such as seasonal borrowing patterns, deposit run-off and business payrolls).

Aside from anticipated needs, unforeseen events can have serious implications for a bank’s liquidity position. For example, fraud, natural disasters or equipment malfunction could all unexpectedly affect liquidity. Even with the most careful planning, banks need to maintain reserves of liquidity to sustain them when the unexpected occurs.

Liquidity takes on importance because of its implications for bank operations and, in the extreme, bank viability. Poor liquidity limits a bank’s flexibility and puts a brake on its ability to take advantage of new loan and investment opportunities. Acute liquidity problems can spell serious trouble for a bank when funds aren’t available to meet depositors’ withdrawal demands. At that point, the bank is liquidity insolvent and can be closed. Because of this, it important that you, as a director, pay close attention to your bank’s liquidity position and are aware of factors that can affect that position. This section of the course looks at some of those factors.

Factors that Affect Liquidity

In general, factors that can influence bank liquidity include its:

• Financial Market Access
• Financial Condition
• Balance Sheet Structure

Financial Market Access

All banks have some degree of financial market access, but smaller banks tend to have less access to financial markets than do larger banks. There are at least a couple of reasons for this. First, smaller banks are not as well known to the markets as their larger counterparts. For example, many on Wall Street are familiar with the financial track record and management of large banking companies such as Citigroup, Bank of America, J.P. Morgan Chase, Wachovia, and Wells Fargo, but few may have heard of Farmers State Bank, Anyplace, USA.

Although Farmers State Bank’s track record may not differ much from that of high profile larger firms, there is a cost of developing financial track record information and making it available to the markets. Unless the sum being raised is large, this cost may be prohibitive. This raises the second point. A significant portion of the cost of raising funds is largely fixed, so that the cost per dollar of funds received goes down as the amount raised goes up. On a per-dollar-raised basis, this makes large transactions less expensive to complete than smaller transactions. Because of these transaction cost considerations and other factors, smaller institutions make less use of financial markets than larger institutions.

Financial Condition

Poor earnings and asset quality, both of which play a large role in a bank’s financial condition, can adversely affect liquidity. Because earnings represent a flow of funds to help meet liquidity needs, low earnings translate into less available cash. Low quality assets or high levels of nonperforming assets (for example, loans with principal and interest payments past due) damage earnings and lock a bank into assets with low marketability. Furthermore, low earnings and poor asset quality raise questions about solvency and can make potential lenders less willing to provide funds.

Balance Sheet Structure

Banks adjust their holdings of assets and liabilities to manage their liquidity. These decisions are reflected on their balance sheets. Thus, it is said that how a bank structures its balance sheet can affect its liquidity position.

A bank is considered to be more liquid when more of its assets and liabilities are concentrated in categories near the top of the balance sheet. The most liquid bank (the one that can most easily handle a surprise need for funds) is one that holds only cash and obtains this cash only through core deposits (and the owners’ capital). However, such a bank would not be very profitable because cash doesn’t earn income. The challenge for bank managers is to maintain a prudent degree of liquidity while still structuring the balance sheet to earn a reasonable profit.

For more information about how liquidity risk affects the structure of balance sheet, move your mouse pointer over the chart below. Once you have reviewed the balance sheet, consider your bank’s funding sources.

Before closing, it is important to note two things that can affect liquidity, but may not be reflected directly on the balance sheet. First, timing differences in the flow of funds from assets and liabilities can leave a bank with excess funds, or not enough, if it does not plan carefully. Funds continually flow in and out of a bank. Inflows may come from principal and interest receipts, noninterest income, asset sales, deposits and other borrowings. Outflows occur from interest and other expense payments, asset additions (most likely loan and investments), and deposit and other borrowing pay downs. Even with good planning, fund inflows and outflows will rarely be the same. As a result, balance sheet timing differences have liquidity consequences.

Second, off-balance-sheet activity can introduce both liquidity sources and potential liquidity drains. For example, if a bank has a large number of loan commitments or unused lines of credit, it may be required to make good on these obligations on short notice. On the other hand, the bank may maintain its own lines of credit with other sources such as correspondent banks or the Federal Home Loan Bank (FHLB). Although you wouldn’t know it just by looking at the balance sheet, a bank with substantial credit lines may be very liquid. Again, however, the stability of these lines may rest on the condition and capital position of the bank. Off-balance-sheet operations of many types have risen substantially over the past decade, even at smaller institutions. It is important that you be aware of the exposures and opportunities presented by off-balance-sheet activity at your bank.