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The obvious difficulty in estimating the latter is that, until the bank goes to the market to borrow, it cannot determine with complete certainty that funds will be available and/or at a price, which will maintain a positive yield spread. Changes in money market conditions may cause a rapid deterioration in a bank's capacity to borrow at a favorable rate. In this context, liquidity represents the ability to attract funds in the market when needed, at a reasonable cost vis-à-vis asset yield. The access to discretionary funding sources for a bank is always a function of its position and reputation in the money markets.

Although the acquisition of funds at a competitive cost has enabled many banks to meet expanding customer loan demand, misuse or improper implementation of liability management can have severe consequences. Further, liability management is not riskless. This is because concentrations in funding sources increase liquidity risk. For example, a bank relying heavily on foreign interbank deposits will experience funding problems if overseas markets perceive instability in U.S. banks or the economy. Replacing foreign source funds might be difficult and costly because the domestic market may view the bank's sudden need for funds negatively. Again over-reliance on liability management may cause a tendency to minimize holdings of short-term securities, relax asset liquidity standards, and result in a large concentration of short-term liabilities supporting assets of longer maturity. During times of tight money, this could cause an earnings squeeze and an illiquid condition.

Also if rate competition develops in the money market, a bank may incur a high cost of funds and may elect to lower credit standards to book higher yielding loans and securities. If a bank is purchasing liabilities to support assets, which are already on its books, the higher cost of purchased funds may result in a negative yield spread.

Preoccupation with obtaining funds at the lowest possible cost, without considering maturity distribution, greatly intensifies a bank's exposure to the risk of interest rate fluctuations. That is why banks who particularly rely on wholesale funding sources, management must constantly be aware of the composition, characteristics, and diversification of its funding sources.

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* Contributed by -
Sayonton Roy,
MBA (Finance), IMT Ghaziabad,
Currently working as Consultant - Global Financial Services (Risk and Business Solutions Group) at Ernst & Young, Mumbai.