INVESTMENT BORROWING DECISIONS

Assessment of the liquidity gap based on the forecasts is essentially one aspect of the liquidity management. The other major task of liquidity management is to manage this liquidity gap by adjusting the residual surplus/deficit balances. Considering the high costs associated with cash forecasting, it is essential that the benefits drawn by the bank from such forecasting should be substantially large to give some residual gains after meeting the forecasting costs. This objective can, however, be attained only if the bank makes prudent investment/borrowing decisions to manage the surplus/deficit. 

There are, however, a few factors which must be considered before deciding on the deployment of excess funds/borrowings for meeting the deficit which are given below:

-  Deposit Withdrawals

-  Credit Accommodation

-  Profit fluctuation

The liquidity level to be maintained by a bank should firstly, provide for deposits withdrawals and secondly to accommodate the increase in credit demands. While deposit withdrawals must be honored immediately, it is also of priority to ensure that legitimate loan requests of customers are met regardless of the funds position. Satisfactory credit accommodation ultimately results in more business for the bank. 

Liquidity is further influenced by the fluctuation in the business profits of the bank. It has already been explained that any fluctuation in the interest rates may result in an increase decrease in the NIM of the bank. If this fluctuation results in a negative growth i.e. a decrease in NIM, then the bank should review its RSAs and RSLs. It might thus resort to gap management, which might affect its liquidity position. On the contrary when the profits are showing increasing growth rates, the bank would prefer to maintain higher liquidity position by utilizing the cash balances for investments loan disbursals. This further improves its profitability levels. 

Considering these factors, the bank should adjust its surplus deficit to meet the liquidity gap. While surplus funds can be invested in short/long-term securities depending on the bank’s investment policy, the shortfalls can be met either by disinvesting the securities or by borrowing funds from the market. This again will depend on the strategical issue of whether the bank prefers to manage its liquidity risk using asset management or liability management. If the bank decides to go for liability management then the investment policy ill be long term. Influencing the strategic issues of bank’s investments are the tactical issues. While the bank may use asset management or liability management in their investment decisions they may nevertheless face certain critical charges in their operational environment which make the strategic policies unsuitable. Implies that if the bank’s strategic policy is liability management, in an increasing interest rate scenario, such a policy will not be advisable. In such a case, the bank will have to go for asset management and the time the interest rates stabilize and revert back to the liability management. Thus, while the bank can take its investment decisions based on its strategic policy the same will have to be reviewed to adopt tactical policy to suit the changes in the operating environment. The important criteria in taking such decisions will also be the yields on investments and the cost of borrowing.