Contrast the approaches open to a bank for covering a need for extra liquidity.
The idea
A bank short of liquidity can follow three broad routes. Asset liquidity management meets the need by selling or running down liquid assets such as securities and cash. The bank stays independent of markets, but it gives up yield, may sell at a loss and shrinks the balance sheet. Liability management meets the need by raising purchased funds such as interbank loans, repos, certificates of deposit or central bank credit. Assets stay intact and the balance sheet grows, but the funding costs interest and can disappear or become dearer exactly when the bank's credit standing weakens. Balanced liquidity management combines the two, holding liquid assets for predictable needs and keeping borrowing capacity for unexpected ones. Compare total cost, including forgone yield and fees, and always weigh funding availability under stress.
A practice question
A bank meets an unexpected need for cash by selling short-term government securities from its portfolio. This approach is best described as:
- liability managementWhy not: Liability management raises purchased funds by borrowing, not by selling assets.
- asset liquidity management - correct
- balanced liquidity managementWhy not: Balanced management combines asset conversion with borrowing; this bank uses only asset sales.
- funding diversificationWhy not: Diversification spreads funding across providers and does not involve liquidating assets.
Converting liquid assets into cash is asset liquidity management. It avoids market funding but sacrifices yield and shrinks the balance sheet.
A harder one
A bank needs USD 100 million for one month. It can sell securities that yield 2.4% a year, with a transaction cost of 0.10% of the amount sold, or borrow in the interbank market at 3.1% a year with no fees. Counting forgone yield and fees on a one-twelfth year basis, which option is cheaper?
- Borrowing, by about USD 42,000 - correct
- Selling securities, by about USD 58,000Why not: Leaves out the 0.10% transaction cost of USD 100,000 on the sale.
- Selling securities, by about USD 600,000Why not: Compares a full year of interest on both sides (3.1m against 2.5m), not one month.
- Selling securities, by about USD 50,000Why not: Divides the transaction cost by 12 although it is a one-off charge on the amount sold.
Selling costs 100m x 2.4%/12 = 200,000 forgone plus 100,000 fees = 300,000. Borrowing costs 100m x 3.1%/12 = 258,333. Borrowing is cheaper by 41,667.
The hardest tier
A bank needs USD 150 million for 90 days (use 90/360). Option 1: sell securities yielding 3.0%, at a sale cost of 0.15% of the amount and a price discount of 0.40% in a thin market. Option 2: borrow at 3.6% plus a one-off fee of 0.10% of the amount. Which is cheaper over the 90 days?
- Selling, by about USD 0.15 millionWhy not: Omits the 0.40% price discount on the securities sold.
- Borrowing, by about USD 0.60 millionWhy not: Omits the 0.10% borrowing fee, which overstates the borrowing advantage.
- Borrowing, by about USD 0.45 million - correct
- Selling, by about USD 3.60 millionWhy not: Charges borrowing a full year of interest at 3.6% for a 90-day need.
Selling: 150 x 3.0% x 0.25 = 1.125 + 0.225 + 0.60 = 1.95. Borrowing: 150 x 3.6% x 0.25 = 1.35 + 0.15 = 1.50. Borrowing is cheaper by 0.45; rollover and stigma risk should still be weighed.
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