An Integrated Model for Liquidity Management and Short-Term Asset Allocation in Commercial Banks

The Working Papers should not be reported as representing the views of the Banco Central do Brasil. The views expressed in the papers are those of the author(s) and do not necessarily reflect those of the Banco Central do Brasil. This work develops an integrated model for optimal asset allocation in commercial banks that incorporates uncertain liquidity constraints that are currently ignored by RAROC and EVA models. While the economic profit accounts for the opportunity cost of risky assets, what may even incorporate a market liquidity premium, it neglects the risk of failure due to the lack of sufficient funds to cope with unexpected cash demands arising from bank runs, drawdowns, or market, credit and operational losses, what may happen along with credit rationing episodes or systemic level dry ups. Given a liquidity constraint that can incorporate these factors, there is a failure probability fP that the constraint will not hold, resulting in a value loss for the bank, represented by a stochastic failure loss fL. By assuming that bankers are risk neutral in their decision about the size of the liquidity cushion, the economic profit less the possible losses due to the lack of liquidity is optimized, resulting in a short-term asset allocation model that integrates market, credit and operational risks in the liquidity management of banks. Even though a general approach is suggested through simulation, I provide a closed form