Liability management is a method used by financial institutions to maintain both working capital and saved capital. The majority of financial institutions, such as banks or trusts, take in large amounts of money that belong, wholly or in part, to other people. Even though they may not have full ownership of the money, these institutions may make investments and spend the money as they see fit. Liability management allows these institutions to both spend money and have enough money on hand to pay people should they ask for their money to be returned.
A liability, in financial terms, is a monetary obligation to a specific party. In the case of a financial institution, this liability is generally money that was given to them by an individual. These liabilities are used as monetary capital for investments and purchases made by the institution.
When a person takes his money to the bank, he gives it control over the funds in exchange for certain benefits. These benefits include perks like checks or interest and offset the fact that he no longer has complete control over his money. When he wants his money returned, all he needs to do is ask for it and the bank gives it back. This releases the bank from any liability but also removes his money from the bank's system.
Most financial institutions use liability management techniques to determine what sorts of cash-on-hand they need to maintain. It is important that the institution has enough money to cover any withdrawals and simple transactions that come up during a business day. This money is non-invested capital that is used to maintain the basic operations of the institution. In general, this represents a small amount of the institution's total assets.
In addition to cash-on-hand, liability management systems help these institutions determine how much money needs to remain liquid and how much can be put into firm and long-term investments. Liquid assets are making money for the institution, but may be converted back into actual money quite quickly. Longer-term investments may have large withdrawal fees and penalties, so institutions want to keep them stable if at all possible.
In most cases, when a person gives money to a financial institution, he enters into a legal contract. In most cases, the contract states that the institution has a period of time in between someone asking for his money and him actually receiving it. This window determines the ratios used in most liability management systems. Smaller windows mean more cash-on-hand and liquid assets, while longer windows mean less.
