3.6Liability management

‘Liability management’ refers to the attention which nancial intermediaries give to

the size and composition of their liabilities. Thus it is a term which can be used to

describe the behaviour of any nancial intermediary, though in practice it is used

most frequently to describe the increasing attention given by banks and building

societies to their deposit liabilities since the 1970s.

Liability management:The practice of varying the interest rate and other terms

applying to liabilities (usually deposits) in order to vary the composition and quantity

of liabilities.

Before the introduction in 1971 of the package of monetary control measures known

as Competition and Credit Control, banks generally accepted the size and composition

of their deposits as given. Protability thus depended upon the skill with which banks

could employ those deposits, i.e. upon assetmanagement. This passive approach to

liabilities arose partly from banks’ monopoly of the payments mechanism – people

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Chapter 3 • Deposit-taking institutions

had to have bank deposits in order to make payment by cheque – and partly from

the uncompetitive nature of the banking system before 1971. Until 1971, banks had

operated an interest rate cartel which made it impossible for banks to ‘manage’

(i.e. bid for) deposits in any signicant way. Competition and Credit Control swept

this away and at the same time removed direct controls on the supply of bank lend-

ing. For the rst time, banks were free to respond to the market demand for loans

provided they could obtain an adequate supply of deposits. The early 1970s were

therefore marked by a dramatic expansion in bank lending (and money supply)

and by a general rise in the rate of interest paid on ‘wholesale’, that is to say large,

usually time, deposits of rms. Furthermore, competition meant that the rates paid

on these deposits became increasingly market-related, rising and falling as the level

of ofcial short-term interest rates rose and fell. We shall return to the consequences

of this in a moment.

The second phase of liability management came in the 1980s. Where previously

the competition had been between banks, it now spread to embrace the boundary

between banks and building societies, and the competition was for ‘retail’ rather

than wholesale deposits. The initial stimulus came from the problems which banks

encountered with their sovereign lending at the end of the 1970s. Looking for a

more secure and protable alternative, their attention was attracted to domestic

mortgages for which there was often an unsatised demand resulting from building

societies’ uncompetitive practices in holding mortgage and deposit rates below

market-clearing levels, with the inevitable queuing for and rationing of mortgages.

As we saw in the last section, the societies responded to this invasion of their

traditional territory by abandoning their interest cartel, by offering features which

made their deposits increasingly similar to those of banks, and by lobbying for

changes in restrictive legislation. The result of all this was the further spread of

market-related interest payments on bank deposits. In 1975 the interest-bearing

fraction of M3 was 0.65; it rose to 0.72 by 1981 and to 0.81 by 1989. When M3 was

then replaced by M4, the interest-bearing proportion jumped from 0.81 to 0.89.

By the end of 1992 it had risen to 0.92.

Money’s own rate:The rate of interest paid on money itself. Usually calculated as

the average of the rates paid on its component parts, weighted by their proportion

of the total.

The monetary implications of liability management are numerous but can be

grouped under two headings. Firstly, as interest-bearing deposits increase as a pro-

portion of broad money, it follows that the weighted averagerate on money as a whole

is increasing. Money is more attractive when interest of, say, 10 per cent is paid on

95 per cent of it than it is when 10 per cent is paid on only half of it. At any given

level of market interest rates, therefore, the rate on money (money’s ‘own rate’) was

rising. Furthermore, it was rising relativeto all other interest rates. Thus money’s

own rate was rising relative to that paid on non-money assets (making money more

attractive relative to other assets); it was also rising relative to the rate charged on

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