Question

--Assume you are a banker. How would you balance the need for liquidity in your investment portfolio with the desire for earnings? If interest rates change, what would be the impact?

Answer 1

As a Banker,

A bank needs a higher degree of liquidity in its assets. The liquidity of assets refers to the ease and certainty with which it can be turned into cash. The liabilities of a bank are large in relation to its assets because it holds a small proportion of its assets in cash. But its liabilities are payable on demand at a short notice.

Therefore, the bank must hold a sufficiently large proportion of its assets in the form of cash and liquid assets for the purpose of profitability. If the bank keeps liquidity the uppermost, its profit will below. On the other hands, if it ignores liquidity and aims at earning more, It will be disastrous for it. Thus in managing its investment portfolio a bank must strike a balance between the objectives of liquidity and profitability. The balance must be achieved with a relatively high degree of safety. This is because banks are subject to a number of restrictions that limit the size of earning assets they can acquire.

The nature of conflict between liquidity and profitability is illustrated in earning assets are taken on the horizontal axis and cash on the vertical axis. CF is the investment possibility line which shows all combinations of cash and earning assets.

For instance, point A denotes a combination of OM of cash and OS of earning assets; and point В shows ON of cash and ОТ of earning assets. Each bank seeks to obtain its optimum point along the line CE which will be a combination of cash and earning assets so as to achieve the highest possible level of earnings consistent with its liquidity and safety.

Many types of assets are available to a commercial bank with varying degrees of liquidity. The most liquid of assets is money in cash. The next most liquid assets are deposits with the central bank, treasury bills and other short-term bills issues by the central and state governments and large firms, and call loans to other banks, firms, dealers and brokers in government securities.

The less liquid assets are the various types of loans to customers and investments in long term bonds and mortgages. Thus the principle sources of liquidity of a bank are its borrowings from the other banks and the central bank and from the sales of the assets.

But the amount of liquidity which the bank can have depends on the availability and cost of borrowings. If it can borrow large amounts at any time without difficulty at a low cost (interest rate), it willhod very little liquid assets. But if it is uncertain to borrow funds or the cost of borrowing is high, the bank will keep more liquid assets in its portfolio.

the banking sector's profitability increases with interest rate hikes. Institutions in the banking sector such as retail banks, commercial banks, investment banks, insurance companies and brokerages have massive cash holdings due to customer balances and business activities.

Increases in the interest rate directly increase the yield on this cash, and the proceeds go directly to earnings..