Forecast the liquidity a bank will require using three techniques, namely the sources-and-uses-of-funds approach, the structure-of-funds approach and liquidity indicators.
The idea
Three techniques forecast the liquidity a bank will need. The sources-and-uses-of-funds approach projects changes in deposits and loans. Gap = projected loan growth − projected deposit growth. The requirement is that gap plus any desired buffer, and a positive gap means the bank must raise funds. The structure-of-funds approach sorts liabilities by how likely they are to leave, into hot money, vulnerable funds and stable core funds. It applies a higher reserve percentage to the volatile classes, then adds the results. Liquidity indicators are ratios. Loans to deposits, loans to total assets and volatile liabilities relative to liquid assets signal less liquidity as they rise. Core deposits to assets and liquid assets to total assets signal more. Check the direction of each ratio.
Formulas
Liquidity requirement by sources and uses of funds
Requirement = (ΔL − ΔD) + buffer
- ΔL
- projected loan growth
- ΔD
- projected deposit growth
- buffer
- any desired liquidity buffer
A positive gap means funds must be raised. Leaving out the deposit growth, or the buffer, are the usual slips.
Liquidity requirement by structure of funds
Requirement = Σ pᵢ × Fᵢ
- pᵢ
- the reserve percentage the bank sets for class i
- Fᵢ
- the funds in class i: hot money, vulnerable funds or stable funds
Higher percentages go on the more volatile classes. Swapping them, or applying one flat rate, misstates the need.
A practice question
Which description fits the structure-of-funds approach to forecasting liquidity needs?
- It forecasts changes in deposits and loans and takes the difference as the funding gapWhy not: That describes the sources-and-uses-of-funds approach.
- It tracks ratios such as loans to deposits and compares them with peersWhy not: That describes liquidity indicators, not the structure of funds.
- It sets the requirement equal to the regulator's minimum reserve percentage on depositsWhy not: The approach uses behavioural categories and bank-set percentages, not a single regulatory rate.
- It sorts liabilities by withdrawal likelihood and applies a reserve percentage to each - correct
The structure-of-funds approach sorts liabilities into hot money, vulnerable and stable funds and applies a higher reserve to the volatile groups.
A harder one
A bank has deposits of USD 6,000 million and loans of USD 4,000 million. Using sources and uses of funds, it forecasts deposit growth of 2.5% and loan growth of 6.0%, and wants a liquidity buffer of 1% of projected deposits. The liquidity it must arrange, in USD million, is closest to:
- 90.0Why not: Takes the funding gap alone and leaves out the liquidity buffer.
- 240.0Why not: Counts loan growth only, ignoring deposit growth and the buffer.
- 151.5 - correct
- 301.5Why not: Adds the buffer to loan growth without subtracting the deposit inflow, which should offset part of the loan growth.
Deposit growth = 150, loan growth = 240, gap = 90. Buffer = 1% x 6,150 = 61.5. Requirement = 90 + 61.5 = 151.5.
The hardest tier
A bank's structure-of-funds requirement is USD 1,810 million. It also forecasts loan growth of USD 250 million against deposit growth of USD 140 million, and the gap is added to the requirement. Its available liquidity is cash of USD 300 million plus securities of USD 1,500 million that can be sold at a 3% haircut. The net liquidity position is:
- A deficit of USD 120 millionWhy not: Counts the securities at full value without the 3% haircut.
- A deficit of USD 165 million - correct
- A deficit of USD 55 millionWhy not: Leaves out the funding gap of USD 110 million from the requirement.
- A deficit of USD 445 millionWhy not: Adds the expected deposit growth to the requirement instead of subtracting it in the funding gap.
Requirement = 1,810 + (250 - 140) = 1,920. Available = 300 + 0.97 x 1,500 = 1,755. Net = 1,755 - 1,920 = -165, a deficit.
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