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Optimal Centralization of Liquidity Management

28 Pages Posted: 24 Aug 2009 Last revised: 22 Oct 2009

Sebastian Pokutta

Georgia Institute of Technology

Christian Schmaltz

University of Aarhus; True North Institute

Date Written: October 19, 2009

Abstract

Liquidity is a key resource that banks have to manage on a daily basis. Large banking groups face the question of how to optimally allocate and generate liquidity: in a central liquidity hub or in many decentralized branches across different time zones, jurisdictions, and FX zones. We rephrase the question as a facility-location problem under uncertainty. We show that volatility is a key driver of the degree of (de-)centralization. As expected, in a deterministic setup liquidity should be managed centrally in the most profitable branch. However, under stochastic liquidity demand and different time zones, FX zones, and jurisdictions we find that liquidity is preferably managed and generated in a decentralized fashion to a certain extend. We provide an analytical solution for the 2-branch model. In our setup, a liquidity center is an option on immediate liquidity. Therefore, its value can be interpreted as the “price of information”, i.e. the price of knowing the demand. Furthermore, we derive the threshold to open a liquidity center and show that it is a function of the volatility and the characteristic of the bank network. Finally, we discuss the n-branch model for real-world banking groups (n = 10 to 60 branches) and show that it can be solved with high granularity (100 scenarios) within less than 30 seconds.

Keywords: Liquidity management, liquidity center location problem, facility location problem, real options

JEL Classification: G21

Suggested Citation

Pokutta, Sebastian and Schmaltz, Christian, Optimal Centralization of Liquidity Management (October 19, 2009). 22nd Australasian Finance and Banking Conference 2009. Available at SSRN: https://ssrn.com/abstract=1458963 or http://dx.doi.org/10.2139/ssrn.1458963

Sebastian Pokutta

Georgia Institute of Technology ( email )

Atlanta, GA 30332
United States

Christian Schmaltz (Contact Author)

University of Aarhus ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

True North Institute ( email )

145-157 St. John Street
London, EC1V 4PY
United Kingdom
+49-17621761996 (Phone)

HOME PAGE: http://www.tninstitute.eu

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