Introduction to Finance

primary reserves 
vault cash and 
deposits held at other depository 
institutions and at Federal Reserve 
Banks
secondary reserves 
short-term 
securities held by banks that can 
be quickly converted into cash at 
little cost
credit (default) risk 
the chance of 
nonpayment or delayed payment of 
interest or principal
Profitability Objective
Bank Liquidity
Bank Solvency
Low Liquidity Risk
High Liquidity Risk
Low Credit Risk
Low Interest Rate Risk
High Credit Risk
High Interest Rate Risk
Conservative Approach
Low Profitability
Low Risk
High Safety
Aggressive Approach
High Profitability
High Risk
Low Safety
Trade-off
against
FIGURE 3.6
 Trade-Off of 
Profi tability Objective against 
Bank Liquidity and Bank 
Solvency

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3.8 Bank Management
69
Liability Management 
A bank’s liabilities can be managed to help the bank maintain 
a desired level of liquidity. This is possible because certain types of bank liabilities are very 
sensitive to changes in interest rates. Included would be negotiable certifi cates of deposit 
(CDs), commercial paper, and federal funds. For example, if a bank needs cash to meet un-
expected depositor withdrawals, it could immediately attract more liabilities by raising short-
term interest rates it will pay on negotiable CDs, or by issuing commercial paper at acceptable 
interest rates being demanded in the marketplace. Likewise, the bank could borrow federal 
funds from other banks that have excess reserves, as long as it is willing to pay that day’s 
interest rate. You should recall that federal funds are overnight loans, and thus the bank may 
have to re-borrow each day for several days to off set liquidity pressures.
Time and savings deposits generally are less sensitive to immediate changes in interest 
rates and, thus, receive less focus from a liability management standpoint. Longer-term debt 
and bank equity capital do not work well in terms of liquidity management because of the time 
it takes for debt and equity securities to be issued or sold.
Liability management is meant to supplement asset management in managing bank 
liquidity. In banks incurring severe liquidity problems, bank managers may fi nd that they 
are unable to even sell their negotiable CDs or commercial paper. Furthermore, if banks pay 
higher and higher interest rates to sell negotiable CDs, they must fi nd assets to invest in that 
will provide returns higher than the cost of funds. Otherwise, profi tability will suff er.