Surplus Balance in Investment Borrowing Decision

In case of a surplus balance, the bank has the option of either maintaining cash balances or investing these excess funds in securities/loans. Though holding adequate cash reserves can eliminate the liquidity risk completely, the cost involved in doing so could be prohibitive, especially for a bank. Hence the bank should make optimum use of its idle funds by investing in such a way that the yields earned are greater. 

There are generally 2 options available to the ban while it makes its investment decisions. It can invest either for a short term and roll over until the funds are required for some other purpose of, invest for a longer period after properly assessing the cash requirements through the forecasting process. 

In this decision making process one has to, however, consider/understand the behavior of the yield curves on the long/short-term investments. Yield curves often are sloping upwards since higher interest rates are associated with long term and relatively less liquid assets. For the, expectations theory which explains the relation between the interest rates and the investment period does not hold good in reality. These occurrences explain the fact that the long-term investments do give higher yields than short-term investments. The firm will also have to consider the transaction cost involved while converting its marketable securities.