Liquidity Management: A Self Study Guide
Basic course
Lesson 3:
Measuring Liquidity on the Balance Sheet
Learning Objectives
At the end of this lesson you should:
•
•
•
•
be able to define and compute the most common liquidity ratios.
understand the advantages and limitations of liquidity measurement based on ratios.
have a sense of the typical value range of certain liquidity ratios in a micro-finance
institution.
be able to identify a set of liquidity ratios that might be appropriate for your
institution to track.
Pre-Test
P1
(Solutions are at the end of the lesson)
Below is a list of ratios used to analyze MFI operations.
Identify the ratios that measure liquidity.
a)
b)
c)
d)
e)
Loan Loss Provision Ratio
Net Financial Margin
Cash Position Indicator
Donations and Grant Ratio
Cash Reserve Ratio
Choose:
A) c)
B) b) and e)
C) c) and e)
D) a), b), c) and e)
P2
The current ratio is a common liquidity ratio used by commercial banks.
A) True
P3
Which of the following statements about ratios if false?
A)
B)
C)
D)
P4
Ratios
Ratios
Ratios
Ratios
are easy to compute and generally have limited data requirements.
allow meaningful comparisons across different MFIs.
give clear indications about future developments.
are often used by external analysts.
Short term loans represent liquid assets and should therefore be included in the
calculation of liquidity ratios.
A) True
GTZ
B) False
B) False
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Liquidity Management: Basic course
3.1
Lesson 3
Introduction to Liquidity Ratios
Use of Balance Sheet Ratios
We already mentioned that only a detailed plan of future cash flows can give the necessary
assurance that a financial institution will be able to meet its payment obligations, not just
on average, but every day. Nevertheless, static balance sheet measures, usually expressed
as a ratio or quotient between certain assets and liabilities, can have many useful
applications for a MFI. Many banks use ratios in addition to detailed cash flow projections
as a tool for high level planning and for formulating simple operating rules. External
analysts, regulatory agencies and investors find them practical, because a ratio can give a
quick indication of the overall liquidity position. Ratios make it easy to compare liquidity
between different institutions or to calculate average liquidity for an entire sector of the
financial industry.
Ratios are also popular because of their limited data pre-requisites. It takes systematic
planning and inputs from all parts of the MFI organization to draw up a credible cash-flow
chart, but all you need to calculate a ratio is the last balance sheet. However, the real
information value of a ratio lies not in its absolute number at a certain balance sheet date.
Rather than looking at such a single snapshot, management should be concerned with the
trends of the ratios over time. While ratios can seldom provide answers about changes in
the MFI's liquidity or operational efficiency, marked trends in their development can point
to questions that merit further investigation.
Current Ratio
Probably the best-known liquidity ratio is the Current Ratio, the quotient of current assets
and current liabilities. Current assets and current liabilities are commonly defined as
falling due within a year from the balance sheet date.
Current Ratio =
Current assets
Current liabilities
The current ratio is typically used by non-banks. For a manufacturing business, for
example, the current ratio essentially consists of cash, accounts receivable, and inventory
as a percentage of accounts payable and other short term debt. This provides a good
indication of the coverage of short-term payment obligations by assets that will selfliquidate over the same time period. Most organizations will strive for a ratio greater than
one, as it indicates a certain liquidity cushion.
For financial institutions, however, the current ratio has rather limited information value.
The problem is that current assets include liquid assets (as per our definition in lesson 1)
plus short-term loans to MFI customers. This is not very practical because it combines the
liquidity safety stock with the most important use of liquidity, the loan portfolio. This is a
particularly serious flaw, since most MFIs lend predominantly short-term. One of the most
important issues in liquidity management is to determine which proportion of the assets
should be held as a liquidity reserve and how much can be loaned out. The current ratio is
of no help in this regard. In fact, an institution that has loaned all its funds and has zero
liquidity would have the same current ratio as a MFI that has not made a single loan and
holds all its current assets as vault cash.
Despite its limited information value, a MFI might still need to track and publish the
current ratio, simply because it is used so widely by donors and propagated in many
comparative studies of the MFI sector1.
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Liquidity Management: Basic course
Lesson 3
Types of Liquidity Ratios for Financial Institutions
Since the current ratio does not capture the essence of liquidity very well, let's take a
systematic look at some of the other liquidity measures that have been developed
specifically for use in financial institutions. We will distinguish three groups of ratios:
asset liquidity measures, liability liquidity measures and combined asset-liability ratios.
Most often, liquidity is stored in liquid assets. Asset liquidity measures therefore
determine the proportions of different categories of liquid and non-liquid assets to the
total asset volume.
3.2
Asset Liquidity Measures
Cash Position Indicator
The cash position indicator compares vault cash and demand deposits at other banks
including the central bank to the total asset base of the institution:
Cash Position Indicator =
Cash and deposits due from banks
Total assets
This ratio obviously ranges between 0 and 1, where a larger proportion of cash implies that
the institution is in a stronger position to handle immediate cash needs.
There is no simple rule as to what the value of the cash position indicator should be. At
the end of 1997, Banco Sol in Bolivia had a value of 7.7%, while Caja de Ahorro y Préstamo
Los Andes showed only 1.7% cash and due from banks. The well-known Grameen Bank in
Bangladesh had a cash position indicator of 1.9% on December 31, 1997.
The limitations of such a snap-shot on December 31st are obvious: is this the seasonal low
of cash after depositors withdrew their savings to prepare for Christmas, or is this the cash
build-up in anticipation of an imminent draw-down of deposits for New Year festivities? Or
does a 7.7% cash position simply mean that Banco Sol overestimated the demand from
borrowers who could absorb their loan capacity? Only after a careful assessment of the
specific operating environment and the liquidity trends, can one attempt to judge whether
a specific cash position indicator is appropriate for a particular MFI.
Capacity Ratio
The mirror image to the cash position is captured by the capacity ratio, which should be
understood as a negative liquidity indicator:
Capacity Ratio =
Net loans
Total assets
Net loans are defined as total loans minus the accumulated loss allowance for bad loans.
The capacity ratio indicates the extent to which an institution has loaned out its funds; the
higher the capacity ratio, the lower the institution's liquidity. Even at zero liquidity, the
capacity ratio will be less than 1, because of the necessary investment in fixed assets. For
many village bank-type MFIs, however, the investment in fixed assets is almost negligible.
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Liquidity Management: Basic course
3.3
Lesson 3
Liability Liquidity Measures
Liability liquidity refers to the ease with which a bank can obtain new debt to acquire cash
assets at low reasonable cost. A potential lender to an MFI will look at the loan
performance, capital base and the composition of the outstanding deposits and other
liabilities of the MFI. Everything else being equal, it will be easier to raise debt from
commercial lenders, if the MFI does not already have most of its business financed with
short-term commercial borrowings or so-called purchased funds. It is preferable for a
financial institution to rely on a large base of retail deposits.
Total Deposit Ratio
A large base of retail deposits would be evidenced by a high total deposit ratio.
Total Deposit Ratio =
Total customer deposits
Total assets
2
The higher the total deposit ratio, the lower is the perceived liquidity risk because
contrary to purchased funds, retail deposits are less sensitive to a change in interest rates
or a minor deterioration in business performance.
When calculating customer deposits, it is important to exclude any potential inter-bank
deposits or other short-term money market borrowings. Sometimes this distinction can
become blurred as in the case of large brokered certificates of deposit (CDs)3. When in
doubt, the litmus test should be the interest rate sensitivity. If the bank acquired the
funds by bidding in an interest-rate competitive market, the CD should be classified as
purchased funds and be excluded from the deposit base.
Interpreting the Total Deposit Ratio
Not all MFIs collect savings deposits. Would that mean that a MFI which is only now
beginning to mobilize savings and has a very low total deposit ratio is threatened by a
liquidity crisis? Certainly not, because in this situation, the majority of the funding would
very likely not come from "hot money" commercial deposits, but rather from equity and
soft loans from donor organizations. Many MFI still consider permanent donor funding the
most convenient source of stable and low cost liquidity. Savings mobilization is becoming
important, because there are simply not enough donor resources available to cover the
funding needs of the growing micro-finance sector.
A low total deposit ratio should therefore be interpreted together with the following
complementary negative liquidity measure, the purchased funds ratio.
Purchased Funds Ratio
The purchased funds ratio measures the amount of commercial short-term funding in
relation to the total balance sheet volume. It is defined as:
Short term borrowings
+ Purchased funds
Purchased Funds Ratio =
Total assets
A large proportion of commercial short term borrowings and other purchased funds
represents a liquidity risk, because this kind of hot money is very sensitive to interest rates
and the perceived credit risk of the borrowing MFI. This funding is usually the first to dry
up at the slightest appearance of financial difficulty, which again is when you would
probably need it most.
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Liquidity Management: Basic course
Lesson 3
Core Deposit Ratio
As the last of many more conceivable ratios on the liability side, we will introduce a
refinement to the total deposit ratio above. The core deposit ratio eliminates the volatile
portion of the deposit mass and emphasizes the stable base of deposits which the
institution can rely on, regardless of seasonal swings.
Core Deposit Ratio =
Core deposits
Total assets
Core deposits can be estimated by plotting the volume of total deposits over time and
drawing a line through the low points of the graph. This base line represents the trend in
the minimum or core deposits, below which in all likelihood the actual deposit level will
never fall.
Figure 3.1
3.4
Measuring Core Deposits
Combined Asset-Liability Measures of Liquidity
Loan-to-Deposit Ratio
Many banks and bank analysts monitor loan-to-deposit ratios as a general measure of
liquidity:
Loan - to - Deposit Ratio =
Net loans
Total deposits
Loans are presumably the least liquid of assets, while deposits are understood as the
primary source of funds. A high ratio indicates illiquidity, because in this case a bank is
fully loaned-up relative to its stable funding. Implicitly, it is assumed that new loans must
be financed with large purchased liabilities. A low ratio suggests that a bank has
additional liquidity, since it can grant new loans financed with stable deposits.
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Liquidity Management: Basic course
Lesson 3
The problem with common loan-to-deposit ratios is that they disregard the composition of
loans and deposits. On the deposit side, it might be useful to focus on core deposits rather
than total deposits. This will be easier to do for MFI managers who have easy access to the
data on deposit development over time, than for an external analyst who relies on limited
balance sheet data.
Likewise, the loan component in the loan-to-deposit ratio would also benefit from a more
differentiated analysis.
The maturity structure of the loans and the degree of
standardization of the loan agreements will have an important influence on the liquidity of
the loan portfolio. In times of high liquidity need, a bank does not have to wait for the
borrowers to slowly pay back their loans but can liquidate entire bundles of loans by selling
them to another financial institution. Even small industrial companies use factoring firms
to mobilize their accounts receivables, so selling portfolios of micro-loans for cash is not
an unrealistic proposition for MFIs4. What makes loans more marketable and thus more
liquid is the standardization of collateral arrangements and payment schedules and a short
maturity of preferably just a few months.
Net Non-Core Funding Dependence
One of the more sophisticated liquidity ratios commonly tracked by financial institutions is
the net non-core funding dependence.
Non-core liabilities - Short term investments
Net Non-Core
=
Funding Dependence
Net loans
Non-core liabilities are defined as non-core (volatile) deposits, purchased funds and other
interest-rate sensitive short-term borrowings.
The net non-core funding ratio indicates how dependent a MFI is on volatile sources to
finance its non-liquid earning assets, i.e. its net loans. The argument is simple: One does
not have to worry about the volatility of non-core liabilities in as far as they are offset by
relatively liquid short-term investments. Subtracting short-term investments from noncore liabilities gives the net non-core funding, which then is compared to the net loan
portfolio.
3.5
MFI-Specific Liquidity Ratios
Reserve Ratio
Although there is no shortage of different liquidity indicators in the commercial banking
literature, surprisingly there is rarely mention of a ratio that compares cash assets to
customer deposits. For MFIs, however, this is often the key question: how much cash
should one hold against savings deposits? Many MFI, such as Rural Bank of Panabo (RBP) in
the Philippines, explicitly track this kind of reserve ratio and define liquidity rules on this
basis. RBP, for example, mandates a 20% cash reserve on all customer deposits. A basic
reserve ratio could be defined as:
Reserve Ratio =
GTZ
Cash assets
Customer deposits
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Liquidity Management: Basic course
Lesson 3
One could debate whether the numerator of the ratio should be cash assets or liquid
assets. The idea of a liquidity reserve would obviously be best captured by including all
liquid assets in the calculation. However, the analogy to a minimum reserve requirement
imposed by the central bank is most obvious when limiting the numerator to vault cash and
demand deposits with other banks. It seems that it is this analogy to the regulatory
minimum reserve that makes the reserve ratio such an attractive indicator for MFIs. We
will talk about minimum reserve requirements and the necessary adjustments to the ratio
analysis in a separate lesson later (lesson 5). At this point, it may suffice to say that
minimum reserves are not liquidity, they are a tax on deposits and thus a subtraction from
liquidity. Minimum reserve holdings with the central bank cannot be used to disburse loans
or cover other cash flow requirements. Only those cash assets that exceed the minimum
reserve constitute usable liquidity.
Why MFIs Use the Reserve Ratio?
The minimum reserve issue is one reason why the reserve ratio is of limited use for
commercial banks. The second problem is that it actually compares the liquidity stock
with the source of liquidity, the deposits. This is a somewhat circular argument with
limited information value from the perspective of a commercial bank. For many MFIs,
however, the reserve ratio is a popular and useful instrument.
The preference of MFIs for the reserve ratio actually reveals an interesting philosophical
difference between micro-lenders and large commercial banks. MFIs which are in the
process of "graduating" from donor funds to retail deposits tend to consider deposits as
very risky funding in terms of liquidity. They are therefore very concerned about
"cushioning" against sudden withdrawals of savings deposits by holding a certain proportion
of the deposits in a cash reserve.
In established commercial banking theory, however, retail deposits are viewed as a safe
cushion of stable resources when compared to other kinds of volatile funding that a bank
might employ. The initial practical experience with voluntary micro-deposits reported in
various field studies appears to confirm that MFIs are often overly wary of the liquidity risk
of deposits. Even very small individual savings from poor populations can be combined into
a substantial and stable core funding base. As many MFI operations begin to resemble that
of a commercial bank in scope and size, the conventional liquidity indicators introduced
above may therefore prove more appropriate than some of the MFI-specific indicators
currently in use.
Liquidity Ratio
Another prominent MFI-specific liquidity indicator is the so-called liquidity ratio.
Liquidity Ratio =
Cash plus expected cash inflows in the period
Anticipated cash outflows in the period
The liquidity ratio is presented here, because it attempts to correct the major flaw of all
ratios introduced so far. Ratios are snapshots of liquidity based on historic data. A ratio
can be a useful predictor of the likelihood that a cash-out might occur, but it is no
substitute for actually planning the timing and size of future cash flows. Such a dynamic
approach to liquidity measurement will be the subject of lesson 4.
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Liquidity Management: Basic course
Lesson 3
Limitations of the Liquidity Ratio
The problem with the liquidity ratio is that one cannot calculate its value without going
through the entire rigor of detailed cash planning. However, once you have established
detailed cash flow projections and can thus calculate absolute cash requirements and
surpluses, what then is the purpose of reducing all this useful information to a simple
ratio? Of course, current cash plus expected inflows should be larger than expected
outflows for the next period. So in order to survive, a MFI would need an ex-post liquidity
ratio of greater than one. Ex post means that the ratio is calculated after explicit liquidity
management activities have been taken into account.
Yet, a liquidity ratio greater one is not enough to prevent a cash shortage halfway through
the planning period. The superior indicator for liquidity in a dynamic environment is the
cumulative daily cash balance, which must remain positive over the entire planning
horizon. The derivation of the cumulative daily cash balance is the objective of lesson 4.
3.6
Recommendations for MFIs
Our survey of the many liquidity ratios employed by commercial banks and MFIs would not
be complete without giving an indication as to which ratios might be best suited for
specific types of operating environments. We suggest distinguishing three basic scenarios
that will help determine the choice of liquidity indicators.
Scenario 1: Small Micro-Lending Institution
The typical MFI fitting this scenario is small with limited professional staff, maybe even
entirely volunteer-based, makes only micro-loans and generally has no voluntary savings
business. Here, the basic cash position indicator would be the most useful ratio.
Since this type of institution does not have access to short-term commercial funding and
does not invest in the short-term money market, the more sophisticated ratios covering
purchased funds and investment balances do not apply. Once such a small micro-lender
does begin mobilizing voluntary deposits, it would be advisable to also track the total
deposit ratio and the reserve ratio.
Scenario 2: Mid-Size MFI
A MFI in this category is characterized by a professional organization, by a sophisticated
loan operation and by significant deposit mobilization. Mid-size MFIs should look at the
above cash position indicator, total deposit ratio and the reserve ratio. As a refinement,
one may consider using the core deposit ratio instead of the total deposit ratio. Those
mid-size MFIs that are actively using or are beginning to develop commercial short-term
funding opportunities should also look at the purchased funds ratio.
Scenario 3: Large Full-Service MFI
The typical MFI in this scenario has highly developed voluntary savings operations,
regularly draws on commercial funding sources and uses sophisticated short-term
investments to store liquidity. Such a MFI would find it worthwhile studying all the above
liquidity ratios plus the loan-to-deposit ratio, the capacity ratio and the net non-core
funding dependence.
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Liquidity Management: Basic course
Ratio History
Name
Current
Ratio
Cash Position
Indicator
Capacity
Ratio
Total Deposit
Ratio
Figure 3.2
Liquidity Ratios – Reference Chart
Definition
Current assets
Current liabilities
Cash and deposits due from banks
Total assets
Net loans
Total assets
Total customer deposits
Total assets
Comment
Primarily used by non-banks. Not
recommended for MFIs.
Measures ability to meet
immediate cash needs.
A negative liquidity ratio. Indicates
the extent to which the bank is
loaned up.
Deposits are considered a stable
source of funding. High total
deposit ratio means low liquidity
risk.
The complementary negative
liquidity measure to the total
deposit ratio. High purchased funds
ratio means high liquidity risk.
Purchased
Funds Ratio
Short-term borrowings and purchased funds
Total assets
Core Deposit
Ratio
Core deposits
Total assets
Refinement to the total deposit
ratio. Considers only the stable
base of deposits.
Loan-toDeposit Ratio
Net loans
Total deposits
High loan-to-deposit ratio means
low liquidity. Relates use of
liquidity (loans) to primary source
of stable funds (deposits).
Net NonCore Funding
Dependence
GTZ
Lesson 3
Indicates how dependent a bank is
Non-core liabilities - Short-term investments on volatile sources to fund its nonNet loans
liquid earning assets (loans). High
net non-core funding dependence
means high liquidity risk.
Reserve
Ratio
Cash assets
Customer deposits
Liquidity
Ratio
Cash plus expected cash inflows
Anticipated cash outflows
Not commonly used in commercial
banks. MFI like reserve ratio
because they see deposits as "risk
capital".
Dynamic, forward-looking ratio.
Limited use in practice.
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Liquidity Management: Basic course
Lesson 3
Figure 3.3
Ratio
Year
Cash
Position
Indicator
Capacity
Ratio
Total
Deposit
Ratio
Purchased
Funds
Ratio
Loan-toDepositRatio
Net NonCore
Funding
Dependenc
e
Reserve
Ratio
Banco Sol, Bolivia
1997
7.7%
80.2%
59.9%
17.5%
133.9%
17.21%
12.9%
Caja Los Andes, Bolivia
1997
1.7%
92.7%
3.9%
22.4%
2,392%
22.1%
44.1%
Grameen Bank, Bangladesh
1997
1.9%
63.7%
29.4%
57.1%
216.9%
53.2%
6.5%
Bank Rakyat, Indonesia1
1996
48.7%
46.9%
84.9%
4.3%
55.3%
-93.7%
57.4%
K-Rep, Kenya
1993
36.2%
58.7%
-/-
-/-
-/-
-/-
-/-
FINCA Costa Rica
1993
4.78%
92.2%
-/-
-/-
-/-
-/-
-/-
Boeing Employees Credit
Union, Seattle / USA
1998
5.0%
50.6%
82.1%
9.2%
61.7%
-63.7%
6.0%
Union Bank of Switzerland
1997
5.5%
25.5%
26.6%
45.1%
95.8%
24.5%
20.7%
Institution
1
Liquidity Profile of Selected Financial Institutions
The balance sheet of Bank Rakyat Indonesia shows deposits with its own branches as a cash asset (48% of total assets), which is an unusual accounting practice and
makes the ratios difficult to compare with other MFIs. Inter-branch claims are not shown in normal external financial statements. Even if the branches are legally
distinct subsidiaries, they would normally be consolidated into the group financial statements.
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Liquidity Management: Basic course
Lesson 3
Comprehension Check
(Please refer to the text to find the answers)
i.
Why are ratios helpful for comparisons across different institutions?
ii.
Why is the current ratio not a useful measure of liquidity in financial institutions?
iii. Does a low cash position indicator necessarily mean that the bank is short of liquidity?
iv. You add up the capacity ratio and the cash position indicator for the same bank at the
same point in time and the sum comes out to be greater than one. Can this be right?
v.
Does a low total deposit ratio always mean low liquidity?
vi. A bank places a money market deposit with your MFI for a week. It has already been
rolled over 5 times in a row. Can you count this deposit as part of your core deposits?
vii. What is better in terms of liquidity: a high or a low net non-core funding dependence
ratio?
viii. Why do commercial banks usually not track the reserve ratio?
ix. What is different about the so-called liquidity ratio compared to all other ratios that
measure liquidity?
statements?
GTZ
Can you compute the liquidity ratio from the MFI's financial
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Liquidity Management: Basic course
Lesson 3
Exercises
(Solutions are at the end of the lesson)
Here is the balance sheet history of a financial institution in Bolivia:
Fomento a Iniciativas Económicas (FIE), Bolivia
Balance Sheet in ($, thousands)
1994
1995
1996
1997
70
100
4,166
-99
4,066
4,237
275
488
5,883
-111
5,773
6,536
303
1000
7,818
-80
7,738
9,041
315
867
12,229
-187
12,042
13,224
369
217
428
426
188
672
308
886
926
4,135
4,823
7,389
10,208
19,172
2,083
2,083
3,038
3,038
2,872
2,872
5,193
5,193
109
652
205
1,469
622
248
3,712
592
384
6,404
571
4,264
Total Liabilities
3,050
5,377
7,560
16,433
Total Equity
1,773
2,012
2,648
2,739
Total Liabilities and
Equity
4,823
7,389
10,208
19,172
Assets
Cash and due from banks
Short-term investments
Loans outstanding
Loan loss reserve
Net loans outstanding
Total current assets
Long term investments
Property and equipment
Other assets
Total Assets
Liabilities
Demand deposits
Time deposits
Short term borrowing
Total current liabilities
Long term liabilities
Quasi capital accounts
Other liabilities
Use this information to complete exercises 1-3.
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Liquidity Management: Basic course
Lesson 3
E1 Liquidity Ratios
i)
Use the balance sheet of Fomento a Iniciativas Económicas (FIE) to calculate the
values of the ratios in the following table.
1994
1995
1996
1997
Cash Position Indicator
Capacity Ratio
Purchased Funds Ratio
Net Non-Core
Funding Dependence
ii)
How do you interpret the declining capacity ratio? Do you see a corresponding
liquidity trend in the cash position indicator? Into which other asset categories did
the "unused" loan capacity go?
iii)
What does a declining purchased funds ratio mean in terms of FIE's liquidity?
E2 Liquidity Ratios
Assume FIE started taking customer deposits in 1994. Add 300; 1,000; 1,300; and 2,000 in
demand deposits ($, thousands) to the balance sheet of each of the years 1994-1997
respectively. Assume that net loans increase by the corresponding amount. Base your
comparisons with Banco Sol on the ratios in figure 3.2.
i)
Calculate the following ratios
1994
1995
1996
1997
Total Deposit Ratio
Loan-to-Deposit Ratio
Reserve Ratio
ii)
How do you interpret the loan-to-deposit ratios of FIE compared to the ratio of its
competitor BancoSol of 1.339? How are the loans funded if not with deposits?
iii)
From your evaluation of the different ratios, which of the two banks has less liquidity
risk, BancoSol or FIE?
E3 Interpreting the Balance Sheet
Take a look at the non-current assets on FIE's balance sheet. Which item stands out as
needing further investigation?
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Liquidity Management: Basic course
Lesson 3
E4 Projecting Future Liquidity Ratios
Fictitious Rural Bank of Africa forecasts that its market for loans will boom in the next five
years. It is expected that the deposit growth will fall short of loan growth, creating a need
for borrowed funds. Rural Bank currently holds $100,000 in loans and has $140,000 in core
deposits. It holds $20,000 in liquid assets and the same amount in short-term funding.
Assume that over the next five years, loans will grow at a compounded annual rate of 20%
and deposits will grow at a rate of 5%. Any shortfalls in liquidity will be made up in the in
the commercial short-term funding market. Assume all other balance sheet items remain
the same as today.
i)
What is Rural Bank's current loan-to-deposit ratio?
ii)
What will be Rural Bank's loan-to-deposit ratio five years from now?
iii)
What will be Rural Bank's net non-core funding dependence five years from now?
E5 Liquidity Comparison Across Institutions
The balance sheets for Micro-Bank and Solidarity Credit are shown below for the years
1998 and 1999 (millions of pesos). During 1999, loan demand rose rapidly and drove up
interest rates.
i)
ii)
iii)
Determine and describe how each bank met its loan demand by observing sources
and uses of funds.
Which bank entered 1999 with greater liquidity? Consider the cash position
indicator, the relationship of liquid assets to total assets, the purchased funds ratio,
and the capacity ratio.
Discuss how the banks' beginning balance sheet position might have affected the
profitability of each bank during 1999 and 2000.
Micro-Bank
1998
Cash items
1998
1999
8
6
6
6
Short-term investments
20
12
6
2
Net loans
52
65
60
84
Long-term investments
20
20
28
22
100
103
100
114
Transaction deposits
25
22
20
17
Core savings and time deposits
67
68
65
62
Purchased funds
0
4
5
24
Total Equity
8
9
10
11
100
103
100
114
Total Assets
Total Liabilities & Equity
GTZ
1999
Solidarity Credit
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Liquidity Management: Basic course
Lesson 3
Multiple Choice Test
(Solutions are at the end of the lesson)
M1
The cash position indicator is defined as:
A) Cash Assets / Liquid Assets
B) Liquid Assets / Net Loans
C) Cash Assets / Total Assets
M2
The purchased funds ratio is defined as:
A) Customer Deposits / Total Assets
B) (Short-Term Borrowing + Purchased Funds)/
Total Assets
C) (Short-Term Borrowing + Purchased Funds)/
Total Loans
M3
Can you compute the liquidity ratio from the MFI's financial statements?
A) Yes
M7
Which one of the ratios below might a MFI calculate that has no voluntary deposit
business?
A) Capacity Ratio
B) Core Deposit Ratio
C) Reserve Ratio
M6
A MFI has no fixed assets and no long-term investments. One minus Capacity Ratio
minus Cash Position Indicator is equal to:
A) Short-Term Investments / Total Assets
B) Current Ratio
C) 0
M5
The reserve ratio is defined as:
A) Cash Assets / Total Assets
B) Cash Assets / Customer Deposits
C) Minimum Reserve / Cash Assets
M4
B) No
The current ratio is not a useful liquidity indicator for financial institutions, because
A) the data might not always be current
B) current assets include short-term loans
C) current assets do not include short-term investments GTZ
15
Liquidity Management: Basic course
Lesson 3
Solutions to Pre-Test
P1
A)
P3
C)
P2
B)
P4
C)
Solutions to Exercises
E1 Liquidity Ratios
i)
Calculation of ratios
1994
1995
1996
1997
1.45%
3.72%
2.97%
1.64%
Capacity Ratio
84.30%
78.13%
75.80%
62.81%
Purchased Funds Ratio
43.19%
41.12%
28.13%
27.09%
Net Non-Core Funding
Dependence
47.60%
43.35%
23.94%
35.37%
Cash Position Indicator
ii)
A declining capacity ratio means that the bank is less loaned up, thus more liquid and
better able to absorb additional loan demand. The cash position indicator does not
show a trend to increased liquidity. You have to remember that cash constitutes
only a part of the liquid assets. A bank that holds most of its liquidity reserve in
immediately available short-term investments and is not subject to minimum reserve
requirements might show a very low cash position indicator, but still be highly liquid.
Unused loan capacity was absorbed by the other asset categories, most importantly
by "other assets", short-term investments and long-term investments.
iii)
The purchased funds ratio is a negative liquidity indicator. A decline would point to
lower liquidity risk, because less of the business is financed with volatile purchased
funds. FIE has been able to attract a significant amount of long-term loans, reducing
the need for short-term funds.
E2
Liquidity Ratios
i)
Calculation of ratios
GTZ
1994
1995
1996
1997
Total Deposit Ratio
5.86%
11.92%
11.30%
9.45%
Loan-to-Deposit Ratio
14.56
6.77
6.95
7.02
Reserve Ratio
23.33%
27.50%
23.31%
15.75%
16
Liquidity Management: Basic course
Lesson 3
ii)
FIE is only beginning to build up a deposit base, while BancoSol has a large
established clientele of savers. For FIE, deposits are not yet the primary source of
loanable funds. Instead FIE relies on long-term loans and short term commercial
funding. It is helpful to interpret the loan-to-deposit ratio side by side with the total
deposit ratio and the capacity ratio.
iii)
This question is difficult to answer only with ratio analysis. However, leaving the
deposit-connected ratios aside, BancoSol shows less liquidity risk on all ratios, except
for the capacity ratio where the difference is small.
E3
Interpreting the Balance Sheet
There is a large jump in 1997 in "other assets" and "other liabilities". Since the amount of
the change in both categories is almost the same, one might speculate that these items are
connected. The reason might be some sort of "pass-through" transaction, where FIE
received special funding for the purpose of holding a specific long-term investment.
Because of their large size, these positions would warrant further research.
E4
Projecting Future Liquidity Ratios
i)
ii)
iii)
71.3%
1.25 ×100, 000 1.055 × 140, 000 = 139.3%
Non-core funding = 20, 000 + 1.25 × 100, 000 − 1.055 × 140, 000 . Subtract liquid assets of
20,000 and divide by loans of 1.25 × 100, 000 = 28.2% .
E5
Liquidity Comparison Across Institutions
i)
Micro Bank covered the net loan increase mainly from liquid assets (short-term
securities and cash) with some contribution from purchased funds. Solidarity Credit
relied mainly on purchased funds, but also drew down liquid assets and sold off some
long-term investments to meet loan demand.
ii)
Micro-Bank is more liquid at the beginning of 1999.
Micro-Bank
Cash Position Indicator
Liquid assets / Total assets
Purchased Funds Ratio
Capacity Ratio
iii)
GTZ
Solidarity Credit
8%
6%
28%
12%
0%
5%
52%
60%
Micro-Bank has a very inexpensive funding base with mostly low interest deposits at
the beginning of both years. The high liquidity at the end of 1998 means an
opportunity loss of income compared to higher earning loans. Micro-Bank goes into
the year 2000 with a higher proportion of fully earning assets and still enjoys the
benefit of a low-cost funding base.
17
Liquidity Management: Basic course
Lesson 3
Solidarity Credit started out with a higher utilization of its loan capacity and a low
reliance on purchased funds. This is a rather profitable situation. Solidarity goes into
the year 2000 almost fully loaned up. Some of the additional earnings from loans will
be eaten up by an increased reliance on expensive purchased funds.
Solutions to Multiple Choice Test
M1
C)
M5
C)
M2
B)
M6
B)
M3
C)
M7
B)
M4
B)
Endnotes:
1
See SEEP Network Financial Services Working Group, Financial Ratio Analysis of Micro-Finance
Institutions, 1995, p. 37
2
One may wonder why the total deposit ratio is considered a liability ratio when the denominator
says "total assets". Since the asset and the liability side of the balance sheet are equal by
definition, total assets here are used simply to avoid the terminological complication that the
total of the liability side is not equal to total liabilities, but to total liabilities and stockholders'
equity.
3
A brokered CD combines the pooled funds of several retail savers. Savings are collected by a
broker and placed with banks in order to achieve a higher interest rate than a small individual
CD would earn.
4
See lesson 7 for more on strategies for converting non-liquid assets into cash.
GTZ
18