Question

In: Accounting

To tackle the liquidity management challenges, Financial Institutions need to estimate the liquidity need. how the...

To tackle the liquidity management challenges, Financial Institutions need to estimate the liquidity need.

how the Sources and Uses of funds approach can be used for estimation?

Solutions

Expert Solution

This approach rests on two simple facts;

  1. For a depository institution, liquidity rises as deposits increase, and loans decrease.
  2. Liquidity decreases when deposits decrease, and loans increase.

The liquidity gap arises when the sources and uses of liquidity do not match. It is the size of the difference between sources and uses of funds. A positive liquidity gap (surplus) arises when the sources of liquidity exceed the uses of liquidity. On the other hand, a negative liquidity gap (deficit) emerges when the uses exceed sources.

The crucial steps for the sources and uses of funds approach for a bank are as follows:

  1. Forecasting loans and deposits for a given planning period.
  2. Calculating the estimated change in loans and deposits for the same period.
  3. Estimating the net liquid funds’ surplus or deficit for the planning period by comparing the estimated change in loans (or other uses of funds) to the estimated change in deposits (or other funds sources).

The bank’s liquidity manager might prepare the following forecasting model:

Estimated change in the total loans for the coming period is a function of:

  1. Projected growth in the economy
  2. Projected quarterly corporate earnings
  3. Current rate of growth in the money supply
  4. Projected prime loan rate or cd rate
  5. The estimated rate of inflation.

Estimated change in total deposits for the coming period is a function of:

  1. Projected growth in personal income in the economy
  2. The estimated increase in retail sales,
  3. The current growth rate of the money supply
  4. The projected yield on the money market deposits
  5. The estimated rate of inflation.

The bank can then estimate its needs for liquidity by calculating;

Estimated liquidity deficit(-)or surplus (+)for the coming period=Estimated change in deposits−Estimated

Future deposits (other fund sources) and loans (other fund uses) can also be calculated by dividing the forecast of future deposit and loan growth into three components:

  1. A trend component, estimated by constructing a trend (constant-growth) line using reference points year-end, quarterly, or monthly deposit and loan totals established over a base period sufficiently long to define a trend growth rate (at least 10 years).
  2. A seasonal component, measuring how other funds sources and other funds use is expected to look like in each week or month due to seasonal factors, relative to the most recent year-end deposit or loan level. The seasonal component compares the average level of deposits and loans for each week over the past 10 years to the average level of deposits and loans for the final week of December over the preceding 10 years.
  3. A cyclical component, reflects the difference between expected deposit and loan levels in each week during the preceding year (measured by the trend and seasonal elements) and the actual volume of total deposits and total loans the bank posted that week.

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