Bank liquidity refers to a bank’s ability to meet its obligations at a reasonable cost when they come due. The point at which a bank becomes illiquid is hard to determine. At that point, the bank may find it difficult, if not impossible, to raise funds quickly at any cost.

Except for failing banks that experience a deposit run, few banks ever reach the point of being totally illiquid. Instead, most banks operate in some middle area, balancing their need for liquidity with their need for earnings. (All else being equal, more liquid assets tend to provide lower returns than do less liquid assets.) Over time, this balance may shift one way or the other depending upon circumstances. What may have been an appropriate level of liquidity when loan demand is low may not be adequate when demand is high. What once may have been a coveted funding source may be displaced by another.

Assessing a bank’s liquidity position can be challenging. An adequate position for one bank may not be sufficient for another. Moreover, a position considered adequate for a bank in one time period may not be so in another. Despite these difficulties, directors are responsible for ensuring that bank management has established processes and procedures to meet current and anticipated funding needs and that contingency plans are in place to meet unexpected funding requirements. Directors and management must therefore monitor their bank’s liquidity position and implement strategies to adjust that position when necessary. This section of the course covers monitoring bank liquidity.

Because the flows of funds into and out of a bank are its lifeblood, monitoring these flows is key in gauging bank liquidity risk. Two useful monitoring tools for judging liquidity are the liquidity worksheet and liquidity ratio summary.

• The liquidity worksheet is essentially a cash flow analysis that many businesses use.
• The liquidity ratio summary is a compilation of commonly used ratios for assessing bank liquidity.

Both tools provide information on the bank’s current liquidity position and give some indication of future funding needs. The latter information permits a thoughtful study of funding sources or investment opportunities. It is likely that your bank provides you with similar reports to help you judge your bank’s liquidity.

Lesson Objectives

After you complete this lesson, you should be able to:

• State why bank liquidity is hard to judge.
• Use the liquidity worksheet or liquidity ratio summary worksheet to determine general liquidity trends at a bank.

Use the following text links to navigate through the lesson material:

Liquidity Worksheet
Liquidity Ratio Summary

Once you have reviewed the Bank Liquidity lesson, complete the Try This at Your Bank exercise: Your Bank's Liquidity.

Liquidity Worksheet

The liquidity worksheet is essentially a cash flow analysis tool; it pins down major sources and uses of funds. The first column provides information on planned funding sources and anticipated uses of funds. The third column provides information on actual operating results so that you can compare what actually occurred with what was forecasted to occur. (The reasons behind large differences should be explored with management because they may be red flags pointing to potential funding problems.) Columns four and five represent liquidity forecasts. Depending on the bank’s circumstances, the forecast period may be as short as one day or as long as a month or more. Generally, the less liquid a bank becomes, the shorter the time interval for the forecast period.

The worksheet is a good planning tool. For example, your bank may plan a new 60-month loan campaign with some expected growth in auto loans. The worksheet would be used to determine how that loan growth will be funded. In exploring various options, you would want to compare the relative cost, maturities and stability of each source.

The worksheet is also a good tool for identifying adverse liquidity trends. For instance, if your bank repeatedly shows a net need for funds, this may be an indication that the bank is becoming less liquid.

Another indication of lessening liquidity, at least for smaller banks, can be found in the composition of cash sources on the worksheet. In this regard, smaller institutions rely heavily on core deposits for funding because of their relatively low cost. As these become exhausted, banks move to other, higher-cost funding sources, like brokered deposits.

Keep in mind, however, that the move to noncore funding may simply be part of a strategy to keep funding costs down by not increasing rates in the local market to raise deposits. Such a rise might result in the bank having to pay higher rates on all of its deposits, rather than only on the small amount it needs to fund additional growth.

Definitions for line items included the table

• Brokered deposits are deposits gathered and aggregated by a broker and placed with banks in amounts less than $100,000 (to stay within insurance limits). The broker places deposits with institutions that pay the highest interest rates.

• Rate-listing services list institutions and the rates they are willing to pay for different types of deposits. Banks use these services to advertise their rates and attract deposits. Large depositors use the service to find institutions that pay the highest rates, which increases the rate of return.

• Federal funds are short-term (typically overnight) loans from other banks that are most commonly used to meet legal reserve requirements. Banks are required to hold a certain percentage of their transaction deposits in reserve as vault cash or in an account with the Federal Reserve. Reserves earn no interest, but shortfalls are subject to penalties. Consequently, banks with reserves above the minimum requirement lend them as “federal funds sold,” with banks in need of reserves borrowing as “federal funds purchased.”

• FHLB advances are loans made by Federal Home Loan Banks (FHLBs) to their members. Banks can be FHLB members and make use of FHLB credit facilities. Because of relatively low costs and flexible lending terms, banks increasingly use FHLB advances to meet their liquidity needs.

• The Federal Reserve, through its discount window, provides primary, secondary and seasonal credit to depository institutions to help them meet their funding needs.

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Liquidity Ratio Summary

The liquidity ratio summary includes a number of commonly used financial ratios to judge bank liquidity. It is a useful tool for judging broad directional movement in a bank’s liquidity position. You can print and use this format as a worksheet to review your bank’s liquidity ratios.

The liquidity ratio summary can help you identify trends in liquidity, as well as how your bank compares with other banks and against budget. While the liquidity ratio analysis worksheet can help you with liquidity planning, remember that the ratios provide only a rough measure of liquidity. The boundary line between liquidity and illiquidity depends on many factors, including the condition of the bank, the bank’s size, financial market access, borrower and depositor characteristics, etc. (For more information, review Factors that Affect Bank Liquidity under Join the Meeting.)

• Note that higher or increasing values for the ratios in the worksheet indicate lessening liquidity.
• When using the liquidity ratio summary worksheet, the key is to look for an overall pattern of rising values over time. This could be an indication of deteriorating liquidity and that you might need to ask management questions about the bank’s liquidity position.
• To aid in your analysis of historical, budget and peer comparisons of these liquidity ratios, it might be helpful to review the Making Financial Comparisons lesson.

For more information about the summary worksheet, move your mouse pointer over the chart below then click on any area outlined with a red box. Once you have reviewed the Liquidity Ratio Summary, print a copy to use as a worksheet and complete the Try This at Your Bank exercise: The Liquidity Ratio Summary.