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BANKING AND INSURANCE

SERVICES
PRESENTATION ON THEORIES OF
LIQUIDITY MANAGEMENT
SUBMITTED TO :- Mrs. GARIMA
SUBMITTED BY :- TANVI SOOD
CLASS :- M.COM II ( SEM. 3 )
ROLL NO. :- 4931

WHAT DO YOU MEAN BY


LIQUIDITY MANAGEMENT ???
A measure of the extent to which a person or
organization has cash to meet immediate and
short-term obligations, or assets that can be
quickly converted to do this.
It implies conversion of assets into cash during the
normal course of business and to have regular
uninterrupted flow of cash to meet outside
current liabilities as and when due and payable
and also ensure availability of money for day to
day business operations.

LIQUIDITY RATIOS

CURRENT RATIO

ACID TEST RATIO


OR
LIQUID RATIO

ABSOLUTE LIQUID
RATIO

A) CURRENT RATIO
= CURRENT ASSETS
CURRENT LIABILITIES

B) LIQUID RATIO
= LIQUID ASSETS
LIQUID LIABILITIES
LIQUID ASSETS= CURRENT ASSETS STOCK PREPAID
EXPENSES.
LIQUID LIABILITIES= CURRENT LIABILITIES BANK
OVERDRAFT

C) ABSOLUTE LIQUID ASSETS


=ABSOLUTE LIQUID ASSETS
CURRRENT LIABILITIES
ABSOLUTE LIQUIS ASSETS=CASH IN HAND + CASH AT
BANK + SHORT TERM INVESTMENTS

THEORIES OF
LIQUIDITY
MANAGEMENT

INTRODUCTION
The basic problem of commercial bank is to have a balance
between liquidity and profitability. A bank deals in the money
of the people. The success of a bank depends upon the
efficiency with which it can provide to its creditors
(depositors) and mainly on the confidence it inspires among
the depositors.
Bank has been able to attract the deposits of the people not
only by promising some returns of their money but also the
amount of liquidity in its assets so that it may be able to
meet any claims upon it in cash on demand. The bank must
ensure adequate cash on demand. The perfect liquid asset
is cash itself because it can fully satisfy the claims of
depositors.
The more cash a bank holds , the more obviously it can offer
cash in exchange for depositors without any difficulty.

Why the need arises ????


If a bank holds a large part of its funds in ready cash without
earning any income on it , its business will result in losses. Bank
must employ the resources in advancing loans and investing
them in high yielding securities .
If banks employ its resources and later on doesnt have enough
cash to meet the demands of customers , then bank will lose the
confidence of public. Ultimately , the survival of bank is
endangered.
There is conflict between liquidity and profitability. Cash has
perfect liquidity but lacks income. At other end, there are some
loans and advances which yield high rate of interest, but hardly
liquid at all. In order to ensure long run earnings, the commercial
bank must retain public confidence in order to continue to
survive and provide for the liquidity needs for the bank.
A number of approaches, ways and means of resolving the
conflicts have been developed from time to time. These
approaches consequently came to be known as THEORIES OF
LIQUIDITY MANAGEMENT.

THEORIES OF LIQUIDITY
MANAGEMENT
1) Commercial Loan Theory
2) Shift ability Theory
3) Anticipated Income Theory
4) Liabilities Management Theory

1) Commercial Loan
Theory
Originated in England during the 18thcentury.
The theory states ;
A Commercial Bank must provide short term liquidating loans to meet
working capital requirements.
Self-liquidating loans refers to the loans which finance movement of goods
through successive stages of production, transportation, storage,
distribution and finally consumption.
Logical basis of the theory
Commercial bank deposits are near demand liabilities and should have
short term self liquidating obligations.
The bank holds a Principle that when money is lent against self liquidating
papers, it is known as Real Bills Doctrine
The doctrine had some criticisms. They were;
A new loan was not granted unless the previous loan was repaid. Banks
should provide loans before the maturity of the previous bills.
Due to Economic Condition the liquidity character of the self liquidating
loans are affected.

During Economic depression


Goods do not move fast through normal channels
Prices fall
Losses to sellers
No guarantee , even the transaction for which loan provided is
genuine and whether debtor will be able to repay the debt.
Another criticism was that
It failed to take cognizance of the fact that the bank can
ensure liquidity of its assets only when they are readily
convertible into cash without any loss
Thus the Commercial loan theory was ignored because of the
criticisms of the DOCRINE.

2) Shift ability Theory

Originated in USA in 1918 by H.G. Moulton


According to this theory, the problem of liquidity is not a problem but
shifting of assets without any material loss.
Moulton specified, to attain minimum reserves, relying on maturing bills is
not needed but maintaining quantity of assets which can be shifted to
other bank whenever necessary.
According to this theory ;
It must fulfill the attributes of immediate transferability to others without
loss
In case of general liquidity crisis, bank should maintain liquidity by
possessing assets which can be shifted to the Central Bank.
Eligibility of Shifting of assets :. Soundness of assets
. Acceptability are distinct.
Thus, as development took place the Commercial Loan theory lost ground
in favor of Shift ability Theory

Blue chip securities which possess high degree of shift ability,


the commercial banks were ready to buy them as a collateral
security for lending purposes.
During depression, the whole industry would be in crisis. The
shares and debentures of well reputed companies would fail to
attract buyers and cost of shifting of assets would be high.
.Blue chip Securities will also lose their shift ability character.
Thus, both Commercial loan as well as Shift ability theory failed
to distinguish liquidity of an individual bank as well as the
banking industry.

3) Anticipated Income Theory


Developed in 1948 by Herbert V. Prochnow.
Loan repayment schedules have to be adopted to the
anticipated income or cash receipts of the borrower.
A loan officer must ensure the future earnings or net cash
inflows of the borrowing firm for amortization of loans.
Increased participation in term lending.
Grant loans even if they are not of self-liquidating nature or if
the assets are not shift able against which loans are given.
Thats what Anticipated Income Theory holds.

4) Liabilities Management Theory


It emerged in the year 1960.
This is one of the important liquidity management theory.
Says that there is no need to follow old liquidity norms like
maintaining liquid assets , liquid investments etc.
According to this theory , an individual bank may acquire
reserves from several different sources by creating
additional liabilities against itself.
These sources include a number of items , some of which
are listed below
A) Time certificate of deposits.
B) Borrowing from other commercial bank.
C) Borrowing from central bank.
D) Raising of capital funds.

A) Time certificate of deposit.


These are negotiable instruments and can be sold by the
holder. These certificates bear different maturity date
ranging from 90 days to 365 days.
Limitation.
These are offered with interest rates.
Commercial banks compete with each other for it.

B) Borrowing from other commercial banks


Loans are generally given on one day, unsecured basis.
Sensitive to market conditions. Rate of bank loan fluctuates
with change in demand and supply in the money market.
Limitation.
Every bank mostly faces shortage.

Time Certificate of Deposit


Specimen 1

Time Certificate of Deposit


Specimen 2

C) Borrowing from central bank


Central bank credit facilities are generally available in the form
of discounting or advances for day to day and seasonal
liquidity needs of the commercial banks registered with the
central bank.
Limitation.
Such loans are relatively costlier.
Available in restrictive terms.
D) Raising of capital funds
Commercial banks can acquire reserves by issue of shares of
different features to general public.
Funds can be built up by retained earnings and it depends
upon the its dividend policy.

ANY
QUERIES