ASSIGNMENT NO: 1

NAME: JUNAID AHMAD

ROLL NO: 45

DEPARTMENT: IBL BBA

SEMESTER: 7TH

ASSIGNMENT: CREDIT MANAGEMENT

TITTLE: Liquidity Risk and Liquidity Risk Management

SUBMITTED TO: SIR SAEED AKBAR

DATE: 25, December, 2022

Introduction
A bank's ability to meet expected and unforeseen cash and collateral obligations at a fair cost and
without suffering intolerable losses is referred to as liquidity. The inability of a bank to fulfill obligations
as they arise is known as liquidity risk. Without having a negative impact on the bank's financial situation
when they are due. A bank's ability to satisfy its commitments as they become due is ensured effective
liquidity risk management, which also lowers the likelihood of a bad situation arising. Given that liquidity
crisis can have systemic effects even at a single institution, this assumes relevance. The capacity of
financial institutions to fund growth in their assets and meet their liabilities when they come due has
traditionally been the definition of liquidity. Banking liquidity has however, under challenging
circumstances; this dependence tends to reduce market liquidity because challenging conditions can
quickly spread from one dimension to the other. Under normal conditions since a financial institution
can acquire funding as long as it is willing to pay the going market rates or has the option of selling or
pledging its assets, liquidity management is essentially a cost-benefit trade-off. In a similar vein, a bank
Liquidity warehousing involves keeping a stock of liquid assets to assure some liquidity at the cost of
lower profits. However, in the event of a bank-specific crisis, that bank may find that its access to
liquidity is severely constrained since its counterparties may be reluctant to lend it money, offer
collateral, or do so in exchange for exorbitant interest rates. For the bank to place its orders during a
systemic liquidity crisis could possibly be impossible.

Liquidity Risk and Liquidity Risk Management

The funding of long-term assets by short-term liabilities exposes the obligations to refinancing or
rollover risk, which increases the banks' liquidity risk. Although liquidity risk often has an individual
component, it can occasionally jeopardize the financial system's liquidity. System. The fundamental
obligation for each bank, in terms of how it operates and its areas of expertise, is to define the liquidity
strategy because, in general, the situation is highly dependent on the unique characteristics of each
financial institution. Bank Loans typically have longer contractual maturities than deposits; therefore
liquidity management must provide a buffer to offset expected withdrawals from deposits. The capacity
to effectively handle deposits, as well as the reduction of liabilities, and to additionally, the bank
receives a yield that is linked to its profitability as it transacts maturities that are vulnerable to these
risks. The profitability of the liquidity risk can be increased by increasing the amount of liquid assets or
by enhancing the alignment of asset and liability flows. This connection also works in the opposite
direction: Since the anticipated cash flows do not materialize, loans in an irregular circumstance will
have an impact on profitability and liquidity. Additionally, there is a connection between capital and
solvency: greater capital limits the creation of liquidity but increases the ability to withstand financial
crises.

Funding liquidity risk and asset liquidity risk are two subcategories of liquidity risk. The exposure to loss
resulting from being unable to complete a transaction at current market prices because of either relative
position size or a temporary drying up is known as asset liquidity risk. A market. When forced to sell, this
might lead to huge losses. The susceptibility to loss if a financial organization is unable to cover its cash
demands is known as funding liquidity risk. This may result in a number of issues, including the inability
to meet margin calls or capital withdrawal requests, adhere to collateral requirements, or complete
debt rollovers. Asset liquidity and funding liquidity risks may combine if an organization is forced to
liquidate assets as a result of these issues. between subsequent rounds of forced selling and declining
prices (resulting in margin calls).In the case of asset liquidity risk, liquidity risk is addressed by limiting
concentrations and the relative market sizes of portfolios, and by diversifying, securing credit lines, or
Limiting cash flow gaps in the event of funding liquidity risk as well as other forms of backup funding.

Fundamental principles for the management and supervision of liquidity risk

Principle 1
A bank is in charge of prudently managing the liquidity risk. A bank should set up a strong liquidity risk
management system that guarantees it keeps enough liquid, including a cushion of Unencumbered, top-
notch liquid assets are needed to resist a variety of stress situations, such as the loss or impairment of
both unsecured and secured funding sources. To protect depositors and prevent potential harm to the
financial system, supervisors should evaluate the effectiveness of a bank's liquidity risk management
strategy and its liquidity position. If a bank is found to be lacking in either area, quick action should be
taken.

Principle 2
An acceptable liquidity risk tolerance for a bank's business plan and function in the financial system
should be stated in clear terms.

Principle 3
To manage liquidity risk and make sure the bank has enough liquidity; senior management should create
a strategy, policies, and practices that are in line with risk tolerance. Senior leadership should Review
data on the bank's liquidity changes consistently, and update the board of directors frequently. The
board of directors of a bank should ensure that senior management properly manages liquidity risk by
reviewing and approving the strategy, policies, and procedures relating to the management of liquidity
at least once each year.

Principle 4
All key business activities (both on- and off-balance sheet) should have internal pricing, performance
assessment, and new product approval processes that take liquidity costs, benefits, and risks into
account. Matching the incentives for individual business lines to take risks with the exposures to
liquidity risk those activities expose the bank as a whole to.

Principle 5
A bank needs a reliable system in place for recognizing, quantifying, tracking, and managing liquidity
risk. This procedure must to incorporate a solid framework for accurately estimating cash flows resulting
from assets, liabilities, and items off the balance sheet over the proper time frame.

Principle 6
Considering legal, regulatory, and operational considerations, a bank should actively monitor and
regulate liquidity risk exposures and funding needs inside and between legal entities, business lines, and
currencies. Liquidity transferability restrictions.

Principle 7
A bank should develop a funding plan that effectively diversifies the sources and duration of funding. It
should continue to have a significant presence in the finance markets it has chosen. Relationships with
funding sources to support efficient funding source diversification. A bank should routinely assess its
ability to promptly raise funds from each source. To make sure that projections of its capacity for
collecting money remain accurate, it should pinpoint the key variables that have the biggest an impact
on that capacity and regularly monitor those variables.

Principle 8
In order to fulfill payment and settlement obligations on time in both regular and stressful
circumstances, a bank should actively manage its intraday liquidity positions and risks. Smooth
operation of the settlement and payment systems.

Principle 9
A bank should actively manage its positions in collateral, separating encumbered assets from
unencumbered ones. A bank ought to keep an eye on the company and physical place where collateral
is kept. And how it might be quickly mobilized.

Principle 10
To find potential sources of risk, a bank should regularly do stress tests for a range of short- and long-
term institution-specific and market-wide stress scenarios. To identify prospective sources of liquidity
stress and make sure that present exposures stay within a bank's specified liquidity risk tolerance. The
results of a stress test should be used by a bank to modify its policies, holdings, and methods for
managing liquidity risk as well as to create efficient backup plans.

Principle 11A bank should have a formal contingency financing plan (CFP) that outlines the
approaches to be taken in the event of a liquidity shortfall. A CFP should provide guidelines for
managing a spectrum of high stress situations, establish distinct lines of authority, provide explicit
invocation and escalation processes, and undergo routine testing and updating to guarantee that it is
operationally reliable.
Principle 12
A bank should have a reserve of unencumbered, high-quality liquid assets to be used as protection
against a variety of scenarios involving liquidity stress, such as those involving the loss or impairment of
sources of money that are both secured and often unsecured. There shouldn't be any operational,
statutory, or legal barriers to leveraging these assets to raise money.