Dificite balance in Investment Borrowing Decisions

The second important question that the bank will have to face is, how to meet the deficit cash balances. The only alternative available to meet its deficit is by borrowing funds from the market. While doing this, the aim of the bank should be to keep its cost of raising such short-term funds as low as possible. The bank also has an option of meeting its deficit by internal sources by adjusting against surplus balances obtained earlier. In this option, the number of forecasting periods plays a vital role. Internal funds can be effectively used when the cost of borrowing is relatively high.

There are various models that discuss the suitable ratio that can be maintained between the cash balances and the investments. Two models, which have been commonly used, are the Baumol Model and the Miller and Orr Model. The cash management model given by Baumol extends the Economic Order Quantity concept used in inventory management to discuss the d\cash conversion size, which influences the average cash holding of the firm.

This model analyses the income foregone when the firm holds cash balances (rather than investing the same in the marketable securities), against the transaction costs incurred when the marketable securities are converted into cash. The Miller and Orr model considers that there will be different cash balances at different periods and thus a firm should accordingly decide on the amount and the timing for the transfer of funds from marketable securities to cash.

Thus, the criteria while taking such decisions will be to increase yields on investments and lower the costs of borrowings. Thus there should be optimization in the investment deposit ratio to ensure that the level of idle funds at any point of time is not as high so as to cut into profitability of the bank. This trade off decision of the bank depends upon its attitude towards the liquidity policy i.e. aggressive/conservative. Depending on the liquidity position to be maintained, the risk preferences and risk factors, management can have a policy which has a relatively large/small amount of liquidity.