A Linear Programming Model for Commercial Bank Liquidity Management

Author(s): Bruce D. Fielitz and Thomas A. Loeffler

Source: Financial Management, Vol. 8, No. 3 (Autumn, 1979), pp. 41-50
Published by: Wiley on behalf of the Financial Management Association International
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Linear

for

ProgrammingModel

Commercial

Bank

Liquidity

Management

Bruce D. Fielitz and Thomas A. Loeffler

Bruce D. Fielitz is Research Professor of Finance

at Georgia State University. Thomas A. Loeffler is a
Financial Analyst in the Office of the Comptroller
of the Currency.

Introduction
The primarypurposeof commercialbankliquidity
managementis to supportotherbankingfunctionsby
maintainingreservesto meet unanticipateddeposit
withdrawalsand an inventoryof near cash funds to
satisfy potentialcreditdemands.Becauseof the substantial volume and the frequentturnoverof assets
and liabilities, liquidity managementrequiresclose
attentionto money marketportfoliomanagementas
well as to the supportof depositand creditactivities.
The numerousconstraintson such activity suggest
that liquiditymanagementmay best be accomplished
using mathematicalprogramming.
This paperdescribesthe developmentof a practical
and usable mathematicalprogrammingmodel for liquiditymanagementin a mediumto largecommercial
bank. Although there are differencesin the models,
the motivation for the application discussed here
comes from Komar [7].
The bank has total assets of approximately$800
million and an investmentportfolio (securitiesand

1979 FinancialManagementAssociation

federal funds sold) of approximately$200 million.

Since the bank has had no prior experiencewith
mathematicalprogrammingtechniques, the model
must be simple in order to insurethat management
understandsand acceptsit. Whilea simplemodelmay
abstractand oversimplifysome real world complexities, the model discussedhere can still improveliquiditymanagement.
The model is designedto help the managermake
decisions by providinga comprehensiveframework
withinwhich to evaluatealternativestrategies.

Development of the Model

Since the mid-1960s, there have been dramatic
fluctuationsin interestrates and in the availabilityof
funds.Especiallyduringperiodsof disintermediation,
commercialbanks have felt the need to manage liquiditymore effectively.
The applicationof a mathematicalprogramming

41

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42

FINANCIALMANAGEMENT/AUTUMN1979

model is in part a responseto such changes in the

natureof financialmarkets.The applicationis further
motivatedby a recognitionthat, evenwhileliquidityis
viewed as supportingother banking functions,it is
possible to realize significant returns by actively
managingliquidityfor profit.
Framework of Model Development
Liquiditymanagementis characterizedby the need
to achievea formalobjectivein a constrainedenvironment. Such achievementis complicatedby the substantialamountof data that must be processed.
As the initial step in developmentof the model,
seniorbankmanagementmet withthe projectteam to
specifythe objectiveof liquiditymanagementand the
operating constraints. The group included the
manager responsiblefor liquidity managementand
managersrepresentingthe credit and deposit functions whoseareasof responsibilitydependon the performanceof the liquiditymanagementfunction.
Afterthis meeting,the projectteamhadto translate
the objective and constraints into a quantitative
model. This was particularlysensitive for model
development,because the project team needed to
quantifyaccuratelythe verbaldescriptionsof the function providedby the seniormanagers,none of whom
had a managementscience background.
In orderto select a singleobjectivefunction,as requiredin a simplifiedmathematicalprogrammingformulationof the model, it was necessaryto determine
whichcriterionfor liquiditymanagement- support
or profit - was more appropriate.The participants
agreed that the support function should take
precedence.Such a rankingof criteriacan be readily
accomplishedin mathematicalprogrammingby designatingthe supportfunctionas a series of constraints
that mustbe satisfiedbeforethe profitabilitycriterion
is maximized.Thus, the model may be interpreted
both conceptually and technically as maximizing
profitabilitywithin the constraintof first supporting
other bank functions.
Thereare, of course,otherconstraintsthat limitthe
ability of the liquiditymanagerto maximizeprofits.
Accountingand regulatoryrestrictions,as well as risk
and return preferencesof the bank managers,constrainthe solution.Each restrictionmust be carefully
delineatedand quantifiedso that the resultingmodel
closelyparallelsthe activitiesof the liquiditymanager.
Any modelof the bankliquiditymanagementfunction must be able to accommodateand processlarge
amounts of data. The mathematicalprogramming
modeldescribedhere facilitatessystematicanalysisof

the vast amountof informationthat confrontsthe liquidity manager daily. Yields on alternativeliquid
assets and liabilities,cash flows, and liquidityneeds
are analyzedsystematicallyin the model.
Behavioral Implications
Liquidity management involves a number of
specialistsmaking independentdecisions. The function may actuallybe performedby severalindividuals;
one, for example, concentrating solely on CDs,
anotherconcernedwith Treasurysecurities,and still
anothermanagingthe municipalportfolio.Typically,
a single individualwho is responsiblefor the overall
performanceof the liquidity managementfunction
coordinatesthese separatefunctions.
A model designedto improvethe efficiencyof liquidity managementmust be able to accommodate
such an environment.Almost by definition,a mathematical programmingmodel focuses on the coordinationof these activitiesvia an interrelatedset of objectivesandconstraints.In this particularapplication,
use of the modelnot only improvedcoordinationand
cooperationamong the managers,but also, for the
first time, made availablequantitativeguidelinesand
objectives.
Technical Implications
To implement the mathematical programming
model for liquiditymanagement,it was necessarynot
only to create a computer-basedmodel, but also to
consider the interface between the model and the
bank's accountingrecordsand data bases.
First came analysisof the relativemerits of batch
processingand time sharing.As will be demonstrated
later, the aggregationof variablesfavors the use of
time sharing.Furthermore,the necessityfor speedto
make decisionsin responseto changingyield structures,securityavailability,and unexpectedcash flows
requiresthat the model be readily accessibleto the
user, withoutdelays in the conversionof raw data to
usable results. A conversational, time sharing
programwas thereforedevelopedto facilitatedata entry andto processquicklythe dataandsolutionoutput
in usable form. (A partialexampleof the program's
conversationalformat is includedas an Appendix.)
To expedite the solution process, automation of
data entry, processing, and retrieval is important.
Therewas no obstaclehere,becausethe bankalready
had highly-sophisticatedinvestment portfolio data
processingprocedures.Withoutthe abilityto interface
with bank accountingrecordsand data bases, a li-

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43

FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT

quidity management model based upon a management science approach would be very difficult to implement.

Exhibit 1. Decision Variables Representing Uses of

Funds*
Variable

The Model
The liquidity management model requires input
information reflecting money and capital market
supply and demand conditions (i.e., yields, maturity,
and availability of money and capital market instruments), tax rates, anticipated credit demands and
deposit withdrawals, and other factors affecting commercial bank liquidity. The output provided by the
model indicates the amount to be held of each type of
liquid asset and liability and the highest net earnings
(lowest net cost) consistent with the constraints.
The liquidity variables are assumed to be continuous. Given the size of the bank's investment portfolio, this assumption appears justified and is consistent with the bank's pre-model experience. To insure
that the continuity assumption is not compromised,
constraints are included in the model reflecting feasible attainment levels for the liquidity variables.
The relationships among variables are assumed to
be linear. While at the extreme, some of the relationships are nonlinear or, more likely, piecewise linear
with step function risk premium yield structures, the
model includes constraints which are designed to
preserve the linearity assumption. Specifically, upper
and lower limits on asset acquisition or sale are formulated so that the viability of the assumed constant
risk premium yield structures is maintained.
Together, the continuity and linearity assumptions
allow the use of linear programming.
The Variables
The following asset categories are considered in the
model as decision variables: 1) Treasury securities, 2)
Agency securities, 3) Municipal securities, 4) Project
notes, 5) Federal funds, 6) Certificates of Deposit, 7)
Repurchase Agreements (and reverse repurchase
agreements), and 8) Federal Reserve Discount Window borrowings. Other variables such as bankers'
acceptances and Eurodollars can easily be incorporated into the model if desired. Each of the
variables is defined appropriately as the purchase or
sale of a liquid asset (say, a Treasury bill) or as the
issuance of a liquidity liability (a certificate of
deposit), depending on whether the instrument is seen
as a source or use of funds. In most cases, the
variables are further delineated by maturity, type of
issue, and other characteristics. Exhibits 1 and 2 present the variables categorized as sources or uses of
funds.

* ., m,)
(=1
x2j(j = . , m2)
1 . * m3)
X3j (=
m4)
X4j (j= , ...
Xsj0= 1 * * * m,)
x6j (j= 1, . , m6)
xlj

Instrument

Type

Treasury Securities
Agency Securities

Asset
Asset

Project Notes
CD- Bank

Asset

MunicipalSecurities

Asset
Asset

ReverseRepurchase
Agreements

Asset

Federal Funds Sold

X7

Asset

*Uses of fundsaredefinedsolelyin termsof the purchaseof liquid

assets. Commercialbanks cannot readily reducetheir liquidity
liabilitiespriorto maturityand,at maturity,reductionsof liquidity
liabilitiesare treatedautomaticallyby the programas exogenous
adjustmentsto the constraints.

Exhibit 2. Decision Variables Representing Sources

of Funds*
Variable
yk (k=
y2k (k=
y3k (k=
Y4k(k=
Y5k(k=
y6k (k=

1, . . , ni)
1, ..., n)
, n3)
1,
1, . . , n4)
1, .., n)
1, . .., n6)

Y7

(k= , .. ., n8)
1 .. , n9)
Yio
y8k

y9k (k=

Instrument
Treasury Securities
Agency Securities
Municipal Securities
Project Notes
CD-Bank
Repurchase Agreements
Federal Funds Bought
CD - Public Money
CD - Money Market
Discount Window
Borrowings

Type
Asset
Asset
Asset
Asset
Asset
Liability
Liability
Liability
Liability
Liability

*Sources of funds are defined as sales of liquid assets and purchases

of liquidity liabilities.

In both Exhibits 1 and 2, the xij and Yik values

represent dollar quantities. In the case of variables
representing the purchase of a liquid asset (use of
funds) or the sale of a liquidity liability (source of
funds), the quantity reflects current market value. In
the case of variables representing the sale of a liquid
asset (source of funds), the quantity reflects book
value.'
The first subscript on variables x and y refers to the
type of variable as defined in the exhibits. In Exhibit 1,
the subscript j indicates specific issues or options
available for purchase under each general category of
the variable. For example, x,j refers to the purchase of
a certificate of deposit from the jth bank, while X3j
'Defining the sale of a liquid asset at book value facilitates the
calculation of the associated objective function coefficient
(discussed in the following section) and the formulation of the
securities' gain (loss) constraint, Equation (14).

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44

FINANCIALMANAGEMENT/AUTUMN1979

refers to the purchaseof a certain municipalwith

given characteristicsreflectingrisk, maturity,coupon
rate,etc. In Exhibit2, the subscriptindicatesa specific
asset availablefor sale or a specificliquidityliability.
In bothexhibits,the mi andn, valuesreferto the total
numberof issuesor optionsavailablein eachcategory.
The Objective Function
The objective function of the model is stated in
terms of maximizingthe after-tax profit generated
from managementof the liquidityvariables.The objective functionhas the generalform:
Maxz =

Z. bijxj-- 2

ij

i k

b,yikY.

(1)

Since the modeldescribedhere is single-period,the

coefficientsof the objectivefunction,bi(j or k) must
describethe relativeattractivenessof purchasingnew
liquid assets, selling some assets from inventory,or
acquiringnew liquidity liabilities, without knowing
how long the instrumentswill be retained or what
futureinterestrate levels will be. Thus, the current,
after-tax yields to maturity (YTMs) of assets and
liabilitiesand (using the terminologyof Komar [7])
the closely-relatedmarketalternativeyields (MAYs)
are used as coefficients in the objective function,
becausetheyaredirectlycomparableandbecausethey
requireonly currentinformationin their calculation.
The model uses managementinterpretationof the
futuredirectionof interestrates (as containedin the
maturitystructureconstraints)to select those assets
and liabilitiesthat generatethe highestreturn(lowest
cost) within the constraintsimposed by futureterm
structureconsiderations.
The bij and bik valuesin the objectivefunctionvary
by sign andby methodof computation.For all use-offundsvariablesdefinedin Exhibit1, the bij valuesare
after-taxyields to maturity.Adjustmentsare madeto
reflect differential tax treatment depending on
whetherthe currentpriceis at a discount,equalto, or
at a premiumin relationto the face value.
For the source-of-fundsvariables reflecting the
issuance of a liability, the bik values are computed
similarly.For the source-of-fundsvariablesin Exhibit
2 that reflectthe sale of assets,however,the bikvalues
are marketalternativeyieldsor yieldsforgone.Again,
adjustmentsare made dependingon whether book
value is at a discount,equal to, or at a premiumin
relationto the face value. All yield calculationsare
made using Fisher's [5] algorithmfor finding exact
ratesof return.Yields are statedas annualcompound
rates.

The signs on the bi(jor k) valuesare as follows.Uses

of funds (assets purchased)representpositive contributionsto profit(yieldreceived)and, therefore,the
bij values are positive. Sources of funds (the sale of
assets or the issuanceof liabilities)representnegative
contributionsto profitbecauseof yield forgoneor expenses incurred.Therefore,the appropriatesign for
the bikvalues is negative,as shownin Equation(1).
The yieldscomputedfor the sourceanduse of funds
variablesare used as the coefficientsin the objective
functionof the linearprogrammingmodel.The model
compares the coefficients economically, and the
algorithmselectsthatcombinationof liquidassetsand
liquidityliabilitiesthat maximizesthe after-taxprofit
to the bank consistentwith the primaryfunctionof
liquiditymanagement.2
The Constraints
Liquidity managementin a commercial bank is
constrainedby the externalenvironmentandby the internal risk and return preferencesof bank management: institutionalconstraintsand management
constraints.
Institutional Constraints. Institutional constraintsare those restrictionsimposedfor accounting,
legal, regulatory,or market reasons. (Such restrictions areinstitutionalin the sensethatthey applyto all
commercialbanks,or at least to all commercialbanks
in a particularstate or of a particulartype.3)They include 1) activity level constraints,2) pledging constraints,and 3) the cash flow constraint.
1. Activity Level Constraints.The activity level
constraintspreventthe modelfromsellingmore of an
asset than is held. These constraints,therefore,refer
only to the assetsrepresentingsourcesof fundsin Exhibit 2 and can be stated simply as:
< Tyk k = 1, . . ., n
Y2k< Ty2k k = 1, . . ., n2
Ylk
*

Y5k

<

Tysk

(2)
(3)

k = 1, ...,.

n5.

(6)

2It should be noted that yield forgone from assets sold is associated
with a decision-making criterion, as are the yields associated with
issuance of liquidity liabilities or the acquisition of liquid assets. To
calculate the actual, financial accounting value of the objective function (profit or loss), it is necessary to add to the objective function
the revenues from assets held in the portfolio prior to the solution of
the model. The program does this automatically.
3For instance, some state chartered banks that are not members of
the Federal Reserve System may hold some of their reserves in the
form of liquid assets. An institutional constraint would apply to this
situation.

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45

FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT

The variables are as defined in Exhibit 2 where the ni

values are the total number of issues of each type of
variable available for sale. The Tyik values represent
the total amount (book value) of each variable held.
2. Pledging Constraints. Commercial banks are
required to hold collateral for the acquisition of certain types of liabilities. Included among these
liabilities are Federal Reserve discount window
borrowings and, for this particular bank, public
money (state and municipal time deposits). For the
latter restriction, the constraint takes the form:
2X3j + 2X4j

zy3k

2y4k

(CD - Public Money) -

2Y8k

Ty3k

2
-

Ty4k,

(7)

where (CD - Public Money) is the amount of state

and municipal time deposits held by the bank and not
maturing during the decision horizon, and the other
variables are as defined previously.
3. Cash Flow Constraint. Certain variables
(sources of funds) contribute positively to cash flow,
and certain variables (uses of funds) contribute
negatively. Sources of cash flow include the sale of
assets or the issuance of liabilities, the Yik. Uses of
cash flow are represented by the purchase of assets,
the xij. Following Komar [7], the cash flow constraint
can be written as:
-

2 aij xij +

1J
ii

2 aik

ii J

Yik > C-M

(8)

where C is defined as exogenous cash flow (projected

credit demand, deposit withdrawals, etc.) such that
C>O represents a cash outflow and C<O represents a
cash inflow. M is the net sum of maturing liquidity
variables. The ai (j or k) values represent adjustments of
book values to actual cash flow values. These adjustments are calculated:4
Current Price
Book Value
(Current Price - Book Value) (Tax Rate)
Book Value

adjustments are made.5

Given the above description of the terms in Equation (8), let c equal the cash flow resulting from the
purchase or sale of liquid assets or the issuance of liquidity liabilities. The model provides sufficient cash
flow to meet obligations as long as c > C-M.
Management Constraints. Management constraints that reflect policy restrictions are peculiar to
individual banks. Constraints are periodically
reviewed and modified to reflect changes in risk/return preferences, projected yields, projected profits,
and other policy-oriented factors. Management constraints include 1) portfolio composition constraints,
2) a liquidity capability constraint, 3) maturity constraints, and 4) a securities gain (loss) constraint.
1. Portfolio Composition Constraints. Portfolio
composition constraints are restrictions preventing
undue reliance on certain liquidity instruments. Such a
constraint might limit the amount of funds that could
be derived from a particular source, or might affect
the distribution of funds among liquid assets. Each
such constraint has the form:
Xij < Uij or Yik < Uik,

where xij or yik represent the appropriate assets and

liabilities, and each Ui (j or k) represents an upper
bound on the value of that particular variable. This
constraint can easily be supplemented by another constraint of the form:
xij 2 Lij or yik

Accrued Interest (1 - Tax Rate)

Book Value

ZX4j -

J
.X4j -

( )

For each of the liquidity variables, the appropriate

4Although tax effects have no immediate, direct impact on cash
flows (the impact is felt only when tax payments are actually made),
the model explicitly considers tax effects on a period-to-period
basis.

Lik,

(11)

where Li (j or k) represents a lower bound beneath

which the value of a variable must not fall.
Rather than restricting activity to some absolute
value, percentage portfolio composition constraints
may also be formulated. Such constraints may have
the form:

aijork) =

Reserve Requirement (%)

(10)

2Y4k + Ty4k

2Y4k + Ty4k + 2y3k + Ty3k

P. (12)

In this illustration, project notes are limited to P percent of the total tax-exempt portfolio. Of course,
many other variations of this basic formulation are
possible.
Portfolio composition constraints allow recognition
5For example, consider agk the coefficient associated with the kth
CD-Money Market instrument issued. When (CDs - Money
Market) are issued, cash available is slightly reduced on the CD
because of reserve requirements. ThUs, agk = 1-0- reserve requirement (%) +0 < 1, where the exact value of the coefficient depends
on the actual reserve requirement.

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FINANCIALMANAGEMENT/AUTUMN1979

46

of the relationshipbetween the amount of funds

securedfrom a particularsource and the yield cost
necessaryto securethose funds.The linearprogramming model assumes the relationshipsare linear;in
practice, however, many of these relationshipsare
nonlinearor, at best, piecewiselinear. In the case of
federalfunds, for example,any bank is theoretically
confrontedwith an upperdollar limit on the amount
of fundsit can buy at a fixedrate.Beyondthis limit, a
further increase in federal funds carries with it a
higheryield cost becauseof the associatedhigherrisk
premium.At the pointwherelendersdemanda higher
rate on the bank'sfederalfundsliabilities,the original
objective function coefficient no longer reflects the
true cost to the bank of this sourceof funds.The establishmentof appropriateupper and lower bounds
for portfoliocompositioncan be used to preservethe
assumedlinear structure.
2. LiquidityCapabilityConstraint.To insurethat
the bank maintainsadequateliquid assets for projected andunanticipateddepositwithdrawalsor credit
demands,a liquiditycapabilityconstraintis included
in the model. Severalformulationsof this constraint
are possible. For example, Komar [7] suggeststhat
changes in net liquid assets be matched dollar-fordollarwith changesin deposits.This is certainlyfeasible, but perhaps overly-conservative,since only a
relativelysmallportionof each dollarof new deposits
is actuallycommittedto liquidityconsiderations.
In the model describedhere, liquiditycapabilityis
related to the assets of the bank. The constraint
providesthat net liquidassetsshouldbe no less thana
givenpercentageof total assets. Managementhas the
abilityto changethe amountof liquidity,basedupon
relevant changes in market conditions, simply by
varyingthe proportionof assets devotedto liquidity.
Obviously,the shadowpriceof thisconstraintis useful
in makingdecisionsregardingthe correctamountof
liquidity.
3. MaturityConstraints.To furtherreflectthe subjective evaluationof futureeconomicconditionsand
to compensatepartiallyfor the absence of a multiperiod framework, the liquidity manager may
valuesof the maturity
manipulatethe right-hand-side
constraints.These constraintstake the form:
MINi < Z mij xij < MAXi,
J

(13)

wherethe mij are maturitycoefficients,the xij liquid

assets, and MINi and MAXi are the minimumand
maximumaveragematuritythat the ith categoryof

assets may achieve. Constraintsmay also be formulatedthat providean absolutelimit (as opposedto
an averagelimit) for all assets in a given category.It
shouldbe apparentfrom the formulationof Equation
(13) that a relationshipexists betweenthe maturity
constraintsand the term structureof interest rates.
Givensufficientdetailin the definitionof the maturity
rangesfor the liquidityvariables,it is possibleto accommodatethe manager'sviewsof futureinterestrate
levels relativeto currentlevels. By manipulatingthe
right-hand-sidevalues, the manager may either
lengthenor shortenthe averagematurityor absolute
maturityof his portfolio.This allows him to injecta
furtherelementof his risk/returnpreferenceinto the
frameworkof the model.
4. Securities' Gain (Loss) Constraint. The
securities'gain (loss) constraintis one of the general
form:
Zliyi < R,

(14)

wherethe li aregain(loss)coefficients,the y, represent

sales of assets, and R is the amountof gains or losses
that may be taken duringthe decision period. This
constraintis usefulin at least two ways. First, to the
extent that bank managers and investors consider
earningsafter securitiesgains or losses to be important, the formulationof this constraintcan contribute
significantlyto managementof the bank's actual,
after-tax earnings.Second, the linear programming
modeladjuststhe variablesin the optimalsolutionaccordingto differencesin objectivefunctioncoefficients
withina very narrowmargin.Thus, to the extentthat
gains or losses are significant, the constraint
representedin Equation(14) providesa technicalimpedimentto the model makingminor swaps.

Modifications
Many banks are unfamiliar with mathematical
programmingtechniques and management science
methods. To reduce the complexity of the initial
applicationof linearprogramming(therebyreducing
any institutional reluctance that might prevent
successfulimplementation),a modifiedversionof the
model may be necessary.
Aggregation of Variables
The model we have describedconsists of several
hundred variables and a similar number of constraints. For a model of more manageableproportions, the bank is now using an aggregatedversion.
For example, instead of separatelyconsideringall

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47

FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT

possiblemunicipalsecuritiesthat providea sourceof

m,), the model
liquidityto the bank (x3j, j = 1,
these
into
securities
maturitycategories,calgroups
the
total
in
each category. Similar
amount
culating
and
aggregations computationsare also made for the
othersourcesand uses variables.In the presentstructureof the model,this reducesthe numberof variables
from severalhundredto between30 and 40.
The number of constraintsin the model is also
reduced,primarilythroughthe eliminationof most of
the activity level constraints.Specifically,instead of
one activity level constraintfor each securityin the
portfolio,the modeluses one suchconstraintfor each
groupof securities.Thus,dependingon the numberof
managerialand institutionalconstraintsspecifiedand
the number of maturity aggregationsdefined, the
model normallyconsists of between25 and 40 constraints.
The appropriateobjectivefunctioncoefficientsfor
the reducedconstraintand variablematrixare determined in the following manner. The market alternative yields used to represent a given maturity
aggregationand category are selected to reflect the
maximumyield forgone by the bank. That is, the
securitywiththe highestmarketalternativeyieldfrom
a particularmaturitycategoryof securitiesrepresents
its category.The rationalefor this selectionis that,if a
sale at this most attractiveyield is indicatedby the
model, then all the securitiesfrom that categoryare
sale candidates.On the otherhand, shoulda sale not
be suggested,then the rangingof the objectivefunction coefficientsallowsthe bankto determinewhether
or not loweryieldingsecuritiesresultin a modification
of the solution.
Similarly,yield to maturitycoefficientsare based
on the yields of securitiesfrom a particularcategory
which have a maturityconsideredrepresentativeof
that category. For example,Treasurybills might be
dividedinto two maturitycategories,0-180 days and
181-360 days. The representativeyields to maturity
may be derivedfrom Treasurybills having 90- and
270-daymaturities,respectively.
All ratesusedarebasedon "asked"or "bid"prices,
as appropriate,such that the yield to the bank is adjusted for dealer commissions.
.

Single-Period Decision Horizon

The currentversion of the model is specifiedin a
single-periodframework.Multiperiodmodels necessitate inclusion of explicit forecasts of interest rate
levels and cash flow conditions.Incorrectforecastsof
these values often result in "optimal"decisionsthat,

in practice,aremuchworsethannon-optimalones [7].
Furthermore,substantialempiricalevidence[4, 9, 10,
11, 12] suggeststhat money and capital marketsare
"efficient,"and that interestrate changescannot be
forecastwith the precisionrequiredby a short-term
liquiditymanagementmodel.
The importanceof intertemporalconsiderationsis
recognized by including in the model a series of
maturity constraints. These constraints permit
managersto entertheir subjectiveassessmentsof the
futuredirectionof interestrates.Thus,the maturityof
any portionor all of the investmentportfoliocan be
lengthenedor shortenedto be consistentwith future
expectationsregardingthe term structureof interest
rates.
Furthermore,because of the ease with which this
model may be accessed,differentaverageand/or absolute maturity limit assumptions can be readily
tested. Such simulationsenable the user to capture
some of the powerof multiperiodmodelswithouttheir
disadvantages.If the model is run frequently,the
penalties for this somewhatmyopic approachto liquidity managementare likely to be small, because
adjustmentsreflectingcurrentmarketconditionsand
anticipatedchangesin marketdirectioncan be made
quickly.6

Implementation
At this particularbank,liquiditymanagementis the
responsibilityof the InvestmentManagementDivision. This division includes an investmentmanager
who determinesportfolio composition and trading
strategiesfor long-termsecurities,a money manager
who determinesliquidity managementpolicies, and
analysts assigned to each of them. The division is
coordinatedby a seniorvice presidentfor investments
and money managementwho reportsdirectlyto the
chief operatingofficer of the bank.
At least once a week, the liquidity management
staff meets to discuss and coordinate plans and
policiesfor the comingweek,the next fourweeks,and
the currentquarter.Bankwideplans and policies are
determined quarterly at the asset/liability senior
managementcommittee meeting. These plans and
policiesare designedto guidethe operationsof the investmentsdivisionas well as the otherdivisionsof the
bank.
At the beginningof eachweek,the seniorvice president for investments,the investmentmanager,andthe
money manager meet to review and revise, as ap'The authors would consider the framework presented in [1] to be an
appropriate extension without undue loss of simplicity.

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48

FINANCIALMANAGEMENT/AUTUMN1979

propriate,the constraintsof the model.This typically

involves analysis of the currentliquidityposition of
the bank, a forecastof potentialdepositwithdrawals,
a forecastof loan demand,and a reviewof expected
interest rate trends. If the forecasteddata are especially volatile at that time, alternativeprojections
are generatedto reflectother possibleanalyses.This
weeklymeetingprovidesthe mostcriticalinputsto the
liquidity managementmodel. It is here where the
managers specify the parametersof the model. If
morethanone alternativeis to be analyzed,eachset of
parametersis listed separately.
An analystthenentersthe datathroughthe model's
interactive computer program. (A portion of the
programis reproducedin the appendix.)It is designed
to make data entry simple. The programis conversational and is written in familiar terms.7 The
programautomaticallyprovidescalculationsof yields
andconstraints,organizingthe data as requiredby the
linear programmingalgorithm. It should be emphasizedthat acceptanceof the model has been substantiallyenhancedbecauseits languageis familiarto
the managersand analysts. One side benefit of the
programis that traineeswho are assignedto enterthe
data becomeacclimatedto the languageand concepts
of investments much more rapidly than they did
before.
Whenthe analysthas completeddata entryfor one
alternative,a solutionis generatedimmediatelyat the
terminal.The outputis in a formatthat readilypermits the managersto interpretthe solution.The output includesthe type of securityclassifiedby maturity
group, if applicable,and the amount to be bought,
sold, or issued for each security and/or group; the
valueof the objectivefunction;marginalvalues;ranging of the objectivefunction;and rangingof the constraints.When alternativepossibilitiesare specified,
data are enteredseparatelyfor each alternative,and
solutionsare successivelygenerated.
When a terminal session with the model is completed,the managersanalyzethe output.Solutionsare
first reviewedin terms of whetherit is feasibleto implement them. In some cases, managersmay have
specified constraints that generate impractical
solutions.Also, the complex interactionsamong the
constraints may cause infeasible or impractical
solutions. Further,a managermay object to a particularsolutionbecauseit is not the one that was an7After the analyst has gained sufficient experience in entering the
data, the program has available an option that suppresses most of
the descriptive material and prompts the user with only a mnemonic
abbreviation.

ticipated or desired. The investmentcommittee is

carefulnot to rejector accept a solutionwithoutexaminingthe results.For example,if, by specifyinga
particularset of parameters,a manageris able to
generate a "forced" solution, comparisons of the
valueof the objectivefunctionfromthe "forced"solution with values from alternativesolutionslead to a
carefulappraisalof profitsforgoneto obtainthe particular"forced"solution.
Whena strategyis both feasibleand practical,it is
includedamongthose consideredfor implementation.
Each solution,basedupondifferentpossibilities,is in
turnsubjectedto this analyticalprocess,and all feasible and practicalstrategiesare retainedfor final consideration.
Upon the completionof screening,strategies are
comparedin termsof the likelihoodof the occurrence
of alternativehappenings,and in terms of the sensitivity of the solutionsto slight deviationsfrom the
postulatedenvironment.Althoughthe solutions can
readilybe rankedaccordingto the valuesof the objective function,the managersmay not be equallycomfortable with each of the strategies.Subjectiverisk
assessments affect the final choice. The strategy
selectedrepresentsa tradeoffbetweena quantitative
measure of expected return and a qualitativerisk
assessment.
The strategyis then reviewedin terms of the sensitivity of the objectivefunctioncoefficientsand the
valuesof the constraints.At this stage
right-hand-side
the solutionmay be foundto be extremelysensitiveto
changesin projectedyields, cash flows, or other exogenousinputs.If so, the strategymay be amendedor
rejectedand the processreturnedto the priorstep. If
the sensitivityis acceptable,that is, if the solutionis
not dramaticallychangedas a resultof slightchanges
in the parameters,the strategyis implemented.
The solutionis not meantto be a rigidprescription
for action. On the contrary,it is consideredto be a
strategicplan to which many tactical modifications
may be necessary.The actual solution of the model
may not be the most importantresultof this process.
The residualbenefitsfrom this analyticalprocessimprovementsin communication,coordination,and,
very often, education- may be moreimportantthan
the technicalfeaturesof the model itself.

Conclusion
The benefitsof constructingandimplementingsuch
a model are not easily measured. Improved communicationand coordinationin managingliquidity

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FIELITZAND LOEFFLER/BANK
LIQUIDITYMANAGEMENT

and better education of the staff are not readily quantifiable. Nor, for that matter, can the profits generated
based upon decisions aided by the model be readily
compared to profits generated based upon the unaided
decisions of the staff. Independent, parallel performance cannot be measured because of the interaction
of the participants with the model prior to strategy
selection. Clearly, it is impossible for managers to
both participate in the process and to select a strategy,
unaided by the model, that would be comparable.
Also, comparison on the basis of an ex post simulation
of the model is not relevant because the managers'
decisions are influenced by model recommendations.
There are, however, indications besides its continued use that the introduction of the model has been
successful. Strategy selection sessions have become a
regular and important part of the liquidity management process. Analysts have been able to assume
responsibility for decision-making much more rapidly
since the model's introduction. Finally, the increase in
emphasis on profitability has caused the Investment
Management Division to be classified in the bank's accounting system as a profit center rather than simply
as a source of funds to support other banking functions.

References
1. Parvis Aghili, Robert-H. Cramer, and Howard E.
Thompson,"Small Bank BalanceSheet Management:
ApplyingTwo-Stage ProgrammingModels,"Journal
of Banking Research (Winter 1975), pp. 246-256.

49

2. Kalman J. Cohen and Frederick S. Hammer, Analytical

Methods in Banking, Homewood, Ill., Richard D.
Irwin, Inc., Part II, "Asset Management," 1966.
3. Kalman J. Cohen and Frederick S. Hammer, "Linear
Programming and Optimal Bank Asset Management
Decisions," Journal of Finance (May 1967), pp.
147-168.
4. Eugene F. Fama, "Efficient Capital Markets: A Review
of Theory and Empirical Work," Journal of Finance
(May 1970), pp. 383-417.
5. Lawrence Fisher, "An Algorithm for Finding Exact
Rates of Return," Journal of Business (January 1966,
Supplement), pp. 111-118.
6. Donald P. Jacobs et al., Financial Institutions,
Homewood, Ill., Richard D. Irwin, 1966.
7. Robert I. Komar, "Developing a Liquidity Management Model," Journal of Bank Research (Spring 1971),
pp. 38-53.
8. Robert W. Llewellyn, Linear Programming, New York,
Holt, Rinehart and Winston, 1964.
9. Charles R. Nelson, Applied Time Series Analysis for
Managerial Forecasting, San Francisco, Holden-Day,
Inc., 1973.
10. Richard J. Rogalski, "Bond Yields: Trends or Random
Walks?" Decision Sciences (October 1975), pp.
688-699.
11. Richard Roll, The Behavior of Interest Rates, New
York, Basic Books, Inc., 1970.
12. V. Kerry Smith, and Richard G. Marcis, "A Time
Series Analysis of Post-Accord Interest Rates," Journal
of Finance (June 1972), pp. 589-605.
13. Harvey M. Wagner, Principles of Operations Research,
Englewood Cliffs, N.J., Prentice-Hall, Inc., 1969.

EASTERN FINANCE ASSOCIATION

CALL FOR PAPERS
The Eastern Finance Association will hold its annual meeting in Savannah, Georgia, April 17-19,
1980. There will be papers and discussions by academicians, by business professionals, and by government specialists on almost all aspects of domestic and international banking, finance, and investments.
Plan to join us and participate.
Send a two-page abstract of your proposal on or before November 30, 1979, to Professor George C.
Philippatos, Program Chairman, The Pennsylvania State University, Department of Finance, 701
Business Administration Building, University Park, PA 16802.

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Appendix*
THIS PORTTION OF THE PROGRAI UTILIZES
INFORMATION FROM BOTH THE
USER AND DATA FILES 'ND COMPUTES THE NECESSARY INPUT DATA ON
MANAGEiENT CONSTRAINTS PREPARATORY TO RUNNING THE LIQUIDITY
MANAGEMENT LINEAR PROGRAMIMING MODEL.

CASH-FLOW

CONSTRAINT.

THE CASH-FLOW CONSTRAINT WILL NOW BE CALCULATED.

ONJE ADDITIONAL
PIECE OF INFORMIATION IS NEEDED.
IWHAT IS THE ESTIMATE OF THE TOTAL CASH-FLOWL C, REQUIR ED OF THE
BANiK FOR THE COMING PERIOD EXCLUDING TRPADING VARIABLES AND
MATURING LIQUIDITY
IF YOU ESTIMATE A NET CASH OUTFLOWJ
VARIABLES?
ENTER C AS A POSITIVE
NUMBER; IF YOU ESTIMATE A NET CASH INFLOW'
FENTER C AS A NEGATIVE NUMBER (E.G.,
(DO NOT ENTER
-1000000).
COMMAS OR THE DOLLAR SIGN.)
ENTER C
?
-3

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

LIQUIDITY

CAPABILITY-SIZE

CONSTRAINT.

THE LIQUIDITY
PORTFOLIO SIZE CONJSTFAINT
CAPABILITY-INVESTMENT
WILL NOT. BE COMiPUTED.
THE INVESTIMENT PORTFOLIO (TREASURY,
AGENCY.
'S,
UNIlCIPAL.,
F.H.A.
PROJECT NOTES.
CD'S,
AND COMMERCIAL PAPER)
iiUST NOT BE GREATER THAN' P PERCENT OF LOANS PLUS INVESTMENTS
( iNVESTMiENTS INCLUDE ALL ASSETS EXCEPT FED FUNJDS SOLD AND CASHAN D- DUE- FROMI-EANKSS) .
I?HAT IS
?.4

P,

ENVTERED AS A DECIMAL BETWEEN 0 AND 1?

WHAT IS THE VALUE OF THE TOTAL LOAN PORTFOLIO?

COMMAS OR THE DOLLAR SIGN.)
?

MUNICIPAL

PORTFOLIO

SIZE

(DO NOT ENTER

CONSTRAINT.

THE SIZE OF THE MUNICIPAL

PORTFOLIO (EXCLUDING PROJECT NOTES AND
F.H.A.
'S)
WILL NOW BE CONSTRAINED.
THE MUNICIPAL
PORTFOLIO
SHOULD NOT BE GREATER THAN M PERCENT OF TOTAL DEPOSITS.
-WHAT IS IM
ENTERED AS A DECIMAL BETWEEN 0 AND 1?
?.2
WHAT IS THE VALUE OF TOTAL DEPOSITS?
DOLLAR SIGN.)
?

(DO NOT ENTER COMM1AS OR THE

*Some responses have been deleted to protect the identity of the bank.

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