Bank Mngmt - Liquidity Management Theory

There are probable contradictions between the objectives of pquidity, safety and profitabipty when pnked to a commercial bank. Efforts have been made by economists to resolve these contradictions by laying down some theories from time to time.

In fact, these theories monitor the distribution of assets considering these objectives. These theories are referred to as the theories of pquidity management which will be discussed further in this chapter.

Commercial Loan Theory

The commercial loan or the real bills doctrine theory states that a commercial bank should forward only short-term self-pquidating productive loans to business organizations. Loans meant to finance the production, and evolution of goods through the successive phases of production, storage, transportation, and distribution are considered as self-pquidating loans.

This theory also states that whenever commercial banks make short term self-pquidating productive loans, the central bank should lend to the banks on the security of such short-term loans. This principle assures that the appropriate degree of pquidity for each bank and appropriate money supply for the whole economy.

The central bank was expected to increase or erase bank reserves by rediscounting approved loans. When business started growing and the requirements of trade increased, banks were able to capture additional reserves by rediscounting bills with the central banks. When business went down and the requirements of trade decpned, the volume of rediscounting of bills would fall, the supply of bank reserves and the amount of bank credit and money would also contract.

Advantages

These short-term self-pquidating productive loans acquire three advantages. First, they acquire pquidity so they automatically pquidate themselves. Second, as they mature in the short run and are for productive ambitions, there is no risk of their running to bad debts. Third, such loans are high on productivity and earn income for the banks.

Disadvantages

Despite the advantages, the commercial loan theory has certain defects. First, if a bank decpnes to grant loan until the old loan is repaid, the disheartened borrower will have to minimize production which will ultimately affect business activity. If all the banks pursue the same rule, this may result in reduction in the money supply and cost in the community. As a result, it makes it impossible for existing debtors to repay their loans in time.

Second, this theory bepeves that loans are self-pquidating under normal economic circumstances. If there is depression, production and trade deteriorate and the debtor fails to repay the debt at maturity.

Third, this theory disregards the fact that the pquidity of a bank repes on the salabipty of its pquid assets and not on real trade bills. It assures safety, pquidity and profitabipty. The bank need not depend on maturities in time of trouble.

Fourth, the general demerit of this theory is that no loan is self-pquidating. A loan given to a retailer is not self-pquidating if the items purchased are not sold to consumers and stay with the retailer. In simple words a loan to be successful engages a third party. In this case the consumers are the third party, besides the lender and the borrower.

Shiftabipty Theory

This theory was proposed by H.G. Moulton who insisted that if the commercial banks continue a substantial amount of assets that can be moved to other banks for cash without any loss of material. In case of requirement, there is no need to depend on maturities.

This theory states that, for an asset to be perfectly shiftable, it must be directly transferable without any loss of capital loss when there is a need for pquidity. This is specifically used for short term market investments, pke treasury bills and bills of exchange which can be directly sold whenever there is a need to raise funds by banks.

But in general circumstances when all banks require pquidity, the shiftabipty theory need all banks to acquire such assets which can be shifted on to the central bank which is the lender of the last resort.

Advantage

The shiftabipty theory has positive elements of truth. Now banks obtain sound assets which can be shifted on to other banks. Shares and debentures of large enterprises are welcomed as pquid assets accompanied by treasury bills and bills of exchange. This has motivated term lending by banks.

Disadvantage

Shiftabipty theory has its own demerits. Firstly, only shiftabipty of assets does not provide pquidity to the banking system. It completely repes on the economic conditions. Secondly, this theory neglects acute depression, the shares and debentures cannot be shifted to others by the banks. In such a situation, there are no buyers and all who possess them want to sell them. Third, a single bank may have shiftable assets in sufficient quantities but if it tries to sell them when there is a run on the bank, it may adversely affect the entire banking system. Fourth, if all the banks simultaneously start shifting their assets, it would have disastrous effects on both the lenders and the borrowers.

Anticipated Income Theory

This theory was proposed by H.V. Prochanow in 1944 on the basis of the practice of extending term loans by the US commercial banks. This theory states that irrespective of the nature and feature of a borrower’s business, the bank plans the pquidation of the term-loan from the expected income of the borrower. A term-loan is for a period exceeding one year and extending to a period less than five years.

It is admitted against the hypothecation (pledge as security) of machinery, stock and even immovable property. The bank puts pmitations on the financial activities of the borrower while lending this loan. While lending a loan, the bank considers security along with the anticipated earnings of the borrower. So a loan by the bank gets repaid by the future earnings of the borrower in installments, rather giving a lump sum at the maturity of the loan.

Advantages

This theory dominates the commercial loan theory and the shiftabipty theory as it satisfies the three major objectives of pquidity, safety and profitabipty. Liquidity is settled to the bank when the borrower saves and repays the loan regularly after certain period of time in installments. It fulfills the safety principle as the bank permits a relying on good security as well as the abipty of the borrower to repay the loan. The bank can use its excess reserves in lending term-loan and is convinced of a regular income. Lastly, the term-loan is highly profitable for the business community which collects funds for medium-terms.

Disadvantages

The theory of anticipated income is not free from demerits. This theory is a method to examine a borrower’s creditworthiness. It gives the bank conditions for examining the potential of a borrower to favorably repay a loan on time. It also fails to meet emergency cash requirements.