Strategies for Liquidity Managers

Asset Liquidity Management or Asset Conversation Strategy

The asset conversion strategy entails storing liquidity in assets, mainly in cash and
marketable securities, so that when liquidity is needed, selected assets can be easily
converted into cash to meet all demands.
Liquid assets have to have the following three characteristics:
1. It has to have a ready market, which means that it can be easily converted into cash
2. It has to have a stable price
3. It has to be reversible, which means the seller can recover his/her original principal
with little risk of loss
The most popular liquid assets include Treasury bills, federal fund loans, certificates of
deposit, municipal bonds, federal agency securities, and euro currency loans. However, a
financial firm is liquid only if it has access, at reasonable cost, to liquid funds in exactly the
amounts required at precisely the time they are needed.
This method is mainly used by smaller financial institutions, because asset liquidity
managements is a less risky approach to liquidity management, compared to borrowing.
However, it is a costly approach. There is an opportunity cost included, the loss of future
earnings on assets that must be sold. Most of the time the financial firm has to pay
commissions when the assets are sold. There is a potential for capital losses if interest rates
are raising. Moreover, selling assets to raise liquidity may weaken the appearance of the
balance sheet. Lastly, liquid assets generally have low returns.

Borrowed Liquidity (Liability) Management Strategy

Liability management strategy is an approach extensively used by the largest firms. It entails
borrowing immediately spendable funds to cover all anticipated demands for liquidity. The
primary sources of borrowed liquidity are including jumbo negotiable CDs, federal funds
borrowings, repurchase agreements, Euro currency borrowings, advances from the Federal
Home Loan Banks, and borrowings at the discount window of the country’s central bank.
There are several advantages for the financial institutions of using the borrowed liquidity
management strategy. The number one advantage of this approach is that it calls for
borrowing funds only when there is a need for funds (instead of storing liquid assets all the
time). Moreover, the volume and composition of the investment portfolio can remain
unchanged and the institution can control interest rates in order to borrow funds.
On the other hand, this method has several advantages as well. First of all, this strategy
offers the highest expected returns, but carries the highest risk due to volatility of interest
rates and possible rapid changes in credit availability. The borrowing cost is always
uncertain and borrowings can be interpreted as a signal of financial difficulties.

Balanced Liquidity Management Strategy

The balanced liquidity management strategy entails combining both asset and liability
management. It entails storing a portion of expected demands for liquidity in assets, while
backstopping other anticipated liquidity needs by advance arrangements for lines of credit
from potential suppliers of funds.