Liquidity Function of Deposits, Stocks, Bonds, and Debentures - Term Paper Example

Liquidity Function Money in the form of deposits offers the least risk, of all financial instruments. But its value is most eroded by inflation. That is why one always prefers to store the funds in financial instruments like stocks, bonds, debentures, etc. The compromise one makes in such investments is that (1) the risk involved is more, and (2) the degree of liquidity, i.e. conversion of the claims into money is less. The financial markets provide the investor with the opportunity to liquidate the investments ((ICMR), Financial Management for Managers, 2003). Keynes coined a new term "liquidity preference" by which his theory of interest is commonly known. Liquidity preference is the desire to hold cash. The money in cash and the rate of interest which is demanded in exchange for it is a "measure of the degree of our disquietude (ICFAI Center for Management Research (ICMR), 2005)." The rate of interest, in Keynes' words, is the "premium which has to be offered to induce people to hold the wealth in some form other than hoarded money." The higher the liquidity preference, the higher will be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The lower the liquidity preference the lower will be the rate of interest that will be paid to the cash-holders. Importance of Liquidity According to Keynes, there are three motives behind the function of holding liquid cash which are discussed in detail below. Transaction Motive: This motive is related to the "need of cash for the current transactions of personal and business exchanges." It is further divided into the income and business motives. The income motive is meant "to bridge the interval between the receipt of income and its disbursement", and similarly, the business motive is "the interval between the time of incurring business costs and that of the receipt of the sale proceeds." Precautionary Motive: The precautionary motive relates to the "the desire to provide for contingencies regarding sudden expenditures and for unforeseen opportunities of advantageous purchases." Banks keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accident, unemployment and other unforeseen contingencies. Money under the speculative motive is for "securing profit from knowing better than the market what the future will bring forth." Liquidity Vs Profitability Short run trade-off exists between liquidity and profitability. Other things remaining constant, the more liquid a bank the lower its return on equity and return on assets (The Banker, 2004). Both asset and liability liquidity contribute to this relationship. Facts about liquidity of a bank: The more liquid a bank, the less profitable the bank Liquid assets earn less than illiquid assets. The shorter the maturity, the lower the yield. The highest yielding loans are loans with the highest default or interest rate risk and are therefore the least liquid. Asset liquidity is influenced by the composition and maturity of funds i.e. the ease with which a bank can convert assets to cash with a minimum loss (Comptroller of the Currency Administrator of National Banks, 2001). Large holdings of cash assets evidently decrease profits because of the opportunity loss of interest income. In terms of investment portfolio, short-term securities yield lower returns compared to long-term securities. As investors value price stability and therefore long-term securities pay a yield premium over short term securities, to induce the investors to extend their holding period. For banks that purchase short-term securities, this increases the liquidity but at higher potential returns. For example, in an environment where market expectations are constant for short-term treasury yields, the treasury yield curve will slope upwards, reflecting liquidity premiums that increase with maturity. A bank's loan portfolio displays the same trade-off where the loans carrying the higher yields are the least liquid. Yields are high as default risk or interest rate risk is substantial and the loan administration is high (Comptroller of the Currency Administrator of National Banks, 2001). Short-term debt of reputed corporations or government guaranteed instruments are the loans that are readily sold and thus carry minimal spread. In contrast, amortized loans though improve liquidity, are long-term in nature as periodic payments increase near term cash flow. The smaller the bank, the greater is the proportion of highly liquid assets usually held. Bank management does not like to sell assets at loss. Therefore, a security whose market value is less than the book value is not considered by the banks as being as liquid as the asset would appear. Short-term securities pledged as collateral against certain types of borrowings cannot be considered liquid. The higher the quality of the bank's assets, the lower will be the rate on new liabilities issued to meet liquidity needs. The greater the proportion of core deposits, the lower will be the rate on new liabilities issued to meet liquidity needs. In terms of liability liquidity, banks with the best asset quality and highest equity capital have greater access to purchased funds while small banks have less access to money and capital markets. In the short run, they also pay lower interest rates and generally report lower returns. Liability Liquidity is measured by a bank's ability to obtain core deposits and purchased funds at cost effective rates that are diversified with respect to markets and maturities (xzClique, 2008). With the perceived default risk of the underlying issuer, the promised yields on loans and securities increase. However, banks that acquire low default risk assets such as government securities forego the risk premium that could be earned from securities in financial markets. Similarly, banks with greater equity financing exhibit lower equity multipliers and thus generate lower returns on equity even with identical return on assets. These banks can borrow funds cheaper because a greater portion of their assets has to be in default before they might fall. Liquidity planning of a bank focuses on guaranteeing the incurrence of lowest cost for immediately available funds. Management should determine whether liquidity and default risk premiums compensate in excess of the additional risk taken in the long run with low quality bank investments. If the management is successful in this task, the long-term earnings will exceed compared to peer banks earnings as so will the ban capital and overall liquidity. Hence, the market value of bank equity will also increase relative to peers as investors bid up the stock prices. Traditional Measures for Liquidity Banks rely both on assets and liabilities as sources of liquidity. Small banks generally have limited access to purchased funds and thus rely primarily on short-term assets. Larger banks in contrast obtain liquid funds mainly via liabilities rather than selling assets (Goodheart, 1998). Traditional liquidity measures focus on balance sheet accounts and measure liquidity in terms of financial ratios. Asset Liquidity Measures Asset liquidity measures the ease of converting an asset to cash with a minimum or no loss. The most liquid assets are the ones, which have short maturity periods and are highly marketable. Liquidity measures in general are expressed in percentage terms as a fraction of total assets. Most small banks maintain substantial investments in highly liquid assets as they provide good liquidity in times of duress. High liquid assets include: I. "Cash and due from banks in excess of required holdings II. Due from banks: interest bearings, short-maturity III. Central bank funds sold and repurchase agreements IV. Short-term treasury securities maturing within one year V. Short-term agency securities within one year VI. Short-term corporate obligations rated Baa or better VII. Short-term municipal securities rated Baa or better VIII. Loans that can be readily sold and/or securitized (Notes on Bank Liquidity)" As stated above, the most marketable asset exhibits low default risk, short maturities and large trading volume in the secondary market. Cash and due from the banks is liquid in the sense that on a daily basis a bank need to clear balance to process transactions. A bank cannot conduct business without deposits at the RBI or other financial institutions. Banks normally minimize cash holdings because cash is an unproductive asset. Only excess cash is truly liquid and this excess includes balances held above legal reserve requirements and the amounts required by correspondent banks for services. During any single day the cash balances can decline without posing serious problems. However, it must be quickly replenished to sustain operations. Thus, though cash and due meets daily liquidity requirements (Frezer). In the past, banks and regulators focused on loan to deposit ratios as in general the banks' loans are relatively illiquid; and the greater a bank's loan to deposit ratio, the lower is the assumed liquidity. Conclusion The best measure of asset liquidity is the one that identifies the dollar amounts of unpledged liquid assets as a fraction of total assets. The greater the fraction, the greater is the ability to sell assets to meet cash needs. Alternatively, liquid assets as a fraction of purchased liabilities suggest whether net liquidity sources are available from assets. This ratio should exceed unity in particular, which indicates that if a bank encounters a run-off of all purchased funds, liquid assets will be sufficient to cover the cash loss. Bibliography (n.d.). Retrieved from http://www.courses.dsu.edu/finance/BUS416/notes/chap14/notes.doc (ICMR), I. C. (2003). Commercial Banking. Hyderabad: ICFAI Center for Management Research. (ICMR), I. C. (2004). Credit Management. Hyderabad: ICFAI Center for Management Research (ICMR). (ICMR), I. C. (2003). Financial Management for Managers. Hyderabad: ICFAI Center for Management Research . Comptroller of the Currency Administrator of National Banks. (2001). Liquidity- Comptroller's Handbook. Comptroller of the Currency Administrator of National Banks. Frezer, J. (n.d.). Comptroller of the Currency Administrator of National Banks System. Reserve Bank of New Zealand Bulliten , pp. 12-14. Goodheart, C. (1998). Liquidity Risk Management. ICFAI Center for Management Research (ICMR). (2005). Money and Banking. Hyderabad: ICFAI Center for Management Research (ICMR). Notes on Bank Liquidity. (n.d.). Retrieved November 10, 2008, from http://www.courses.dsu.edu/finance/BUS416/notes/chap14/notes.doc The Banker. (2004, June 02). Cost Control for Liquidity and Liability. Retrieved November 10, 2008, from The Banker: http://www.thebanker.com/news/fullstory.php/aid/1617/Cost_control_for_liquidity___liability.html xzClique. (2008, November 10). Credit Cards: Leverage, Liqiuidity and liability. Retrieved November 10, 2008, from xzClique: http://www.xzclique.com/2008/11/credit-cards-leverage-liquidity-and-liability/ Read More