Liquidity Management: A Self Study Guide Basic course. Measuring Liquidity on the Balance Sheet

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1 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 (Solutions are at the end of the lesson) P1 Below is a list of ratios used to analyze MFI operations. Identify the ratios that measure liquidity. a) Loan Loss Provision b) Net Financial Margin c) Cash Position Indicator d) Donations and Grant e) Cash Reserve Choose: A) c) B) b) and e) C) c) and e) D) a), b), c) and e) P2 P3 P4 The current ratio is a common liquidity ratio used by commercial banks. A) True B) False Which of the following statements about ratios if false? A) s are easy to compute and generally have limited data requirements. B) s allow meaningful comparisons across different MFIs. C) s give clear indications about future developments. D) s 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 B) False GTZ 1

2 3.1 Introduction to Liquidity s Use of Balance Sheet s 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. s make it easy to compare liquidity between different institutions or to calculate average liquidity for an entire sector of the financial industry. s 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 Probably the best-known liquidity ratio is the Current, 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 assets Current = 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 sector 1. GTZ 2

3 Types of Liquidity s 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 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, The limitations of such a snap-shot on December 31 st 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 The mirror image to the cash position is captured by the capacity ratio, which should be understood as a negative liquidity indicator: Net loans Capacity = 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. GTZ 3

4 3.3 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 A large base of retail deposits would be evidenced by a high total deposit ratio. Total Deposit = Total customer deposits 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 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 The purchased funds ratio measures the amount of commercial short-term funding in relation to the total balance sheet volume. It is defined as: Purchased Funds = Short term borrowings + Purchased funds 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. GTZ 4

5 Core Deposit 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 = Core deposits 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 Measuring Core Deposits 3.4 Combined Asset-Liability Measures of Liquidity Loan-to-Deposit Many banks and bank analysts monitor loan-to-deposit ratios as a general measure of liquidity: Net loans Loan - to - Deposit = 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. GTZ 5

6 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 MFIs 4. 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. Net Non-Core Non-core liabilities - Short term investments = 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 s Reserve 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: Cash assets Reserve = Customer deposits GTZ 6

7 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? 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 Another prominent MFI-specific liquidity indicator is the so-called liquidity ratio. Liquidity = 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. s 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. GTZ 7

8 Limitations of the Liquidity 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 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. GTZ 8

9 History Figure 3.2 Liquidity s Reference Chart Name Definition Comment Current Current assets Current liabilities Primarily used by non-banks. Not recommended for MFIs. Cash Position Indicator Cash and deposits due from banks Measures ability to meet immediate cash needs. Capacity Net loans A negative liquidity ratio. Indicates the extent to which the bank is loaned up. Total Deposit Total customer deposits Deposits are considered a stable source of funding. High total deposit ratio means low liquidity risk. Purchased Funds Short-term borrowings and purchased funds The complementary negative liquidity measure to the total deposit ratio. High purchased funds ratio means high liquidity risk. Core Deposit Core deposits Refinement to the total deposit ratio. Considers only the stable base of deposits. Loan-to- Deposit 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 Non- Core Funding Dependence Non-core liabilities - Short-term investments Net loans Indicates how dependent a bank is on volatile sources to fund its nonliquid earning assets (loans). High net non-core funding dependence means high liquidity risk. Reserve Cash assets Customer deposits Not commonly used in commercial banks. MFI like reserve ratio because they see deposits as "risk capital". Liquidity Cash plus expected cash inflows Anticipated cash outflows Dynamic, forward-looking ratio. Limited use in practice. GTZ 9

10 Figure 3.3 Liquidity Profile of Selected Financial Institutions Institution Year Cash Position Indicator Capacity Total Deposit Purchased Funds Loan-to- Deposit- Net Non- Core Funding Dependenc e Reserve Banco Sol, Bolivia % 80.2% 59.9% 17.5% 133.9% 17.21% 12.9% Caja Los Andes, Bolivia % 92.7% 3.9% 22.4% 2,392% 22.1% 44.1% Grameen Bank, Bangladesh % 63.7% 29.4% 57.1% 216.9% 53.2% 6.5% Bank Rakyat, Indonesia % 46.9% 84.9% 4.3% 55.3% -93.7% 57.4% K-Rep, Kenya % 58.7% -/- -/- -/- -/- -/- FINCA Costa Rica % 92.2% -/- -/- -/- -/- -/- Boeing Employees Credit Union, Seattle / USA % 50.6% 82.1% 9.2% 61.7% -63.7% 6.0% Union Bank of Switzerland % 25.5% 26.6% 45.1% 95.8% 24.5% 20.7% 1 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. GTZ 10

11 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? Can you compute the liquidity ratio from the MFI's financial statements? GTZ 11

12 Exercises (Solutions are at the end of the lesson) Here is the balance sheet history of a financial institution in Bolivia: Assets Fomento a Iniciativas Económicas (FIE), Bolivia Balance Sheet in ($, thousands) Cash and due from banks Short-term investments Loans outstanding 4,166 5,883 7,818 12,229 Loan loss reserve Net loans outstanding 4,066 5,773 7,738 12,042 Total current assets 4,237 6,536 9,041 13,224 Long term investments Property and equipment Other assets ,135 Total Assets 4,823 7,389 10,208 19,172 Liabilities Demand deposits Time deposits Short term borrowing 2,083 3,038 2,872 5,193 Total current liabilities 2,083 3,038 2,872 5,193 Long term liabilities 109 1,469 3,712 6,404 Quasi capital accounts Other liabilities ,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 Use this information to complete exercises 1-3. GTZ 12

13 E1 Liquidity s i) Use the balance sheet of Fomento a Iniciativas Económicas (FIE) to calculate the values of the ratios in the following table. Cash Position Indicator Capacity Purchased Funds Net Non-Core Funding Dependence ii) iii) 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? What does a declining purchased funds ratio mean in terms of FIE's liquidity? E2 Liquidity s Assume FIE started taking customer deposits in Add 300; 1,000; 1,300; and 2,000 in demand deposits ($, thousands) to the balance sheet of each of the years 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 Total Deposit Loan-to-Deposit Reserve ii) iii) 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? 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? GTZ 13

14 E4 Projecting Future Liquidity s 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) iii) What will be Rural Bank's loan-to-deposit ratio five years from now? 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) Determine and describe how each bank met its loan demand by observing sources and uses of funds. ii) 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. iii) Discuss how the banks' beginning balance sheet position might have affected the profitability of each bank during 1999 and Micro-Bank Solidarity Credit Cash items Short-term investments Net loans Long-term investments Total Assets Transaction deposits Core savings and time deposits Purchased funds Total Equity Total Liabilities & Equity GTZ 14

15 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 The reserve ratio is defined as: A) Cash Assets / Total Assets B) Cash Assets / Customer Deposits C) Minimum Reserve / Cash Assets M4 A MFI has no fixed assets and no long-term investments. One minus Capacity minus Cash Position Indicator is equal to: A) Short-Term Investments / Total Assets B) Current C) 0 M5 Which one of the ratios below might a MFI calculate that has no voluntary deposit business? A) Capacity B) Core Deposit C) Reserve M6 Can you compute the liquidity ratio from the MFI's financial statements? A) Yes B) No M7 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

16 Solutions to Pre-Test P1 A) P3 C) P2 B) P4 C) Solutions to Exercises E1 Liquidity s i) Calculation of ratios Cash Position Indicator 1.45% 3.72% 2.97% 1.64% Capacity 84.30% 78.13% 75.80% 62.81% Purchased Funds 43.19% 41.12% 28.13% 27.09% Net Non-Core Funding Dependence 47.60% 43.35% 23.94% 35.37% ii) iii) 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. 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 s i) Calculation of ratios Total Deposit 5.86% 11.92% 11.30% 9.45% Loan-to-Deposit Reserve 23.33% 27.50% 23.31% 15.75% GTZ 16

17 ii) iii) 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. 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 s i) 71.3% ii) , , 000 = 139.3% iii) 5 5 Non-core funding = 20, , , 000. Subtract liquid assets of 5 20,000 and divide by loans of , 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 Micro-Bank Solidarity Credit Cash Position Indicator 8% 6% Liquid assets / 28% 12% Purchased Funds 0% 5% Capacity 52% 60% iii) 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. GTZ 17

18 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 Analysis of Micro-Finance Institutions, 1995, p 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