Liquidity Risk Management

This risk arises due to mismatch of assets and liabilities Short term borrowing and long term lending results into this risk Short term borrowing at lower cost and long term lending at a higher yield Profit is ensured but liquidity risk arises Banks need to maintain short as well as long term liquidity

Approaches to Liquidity Risk Mgt.

Fundamental Approach
To ensure long term liquidity

Technical Approach
To ensure short term liquidity

Fundamental Approach
To reduce long term liquidity risk Adjustment of long term maturity of assets and liabilities Diversification and broadening of sources and uses of funds This is done by either liability creation or by assets liquidation

Assets Management
Holding near cash assets Depending on Primary or Secondary reserve Primary reserve CRR Secondary reserve Marketable securities held for liquidity purpose

Considerations while assets management

If funds are put up in Govt. security
Liquidity, safety are higher and yield is moderate

If funds are put up in corporate instruments

Return is higher but liquidity and safety are lower

Liability Management
Sources of fund is focused Funds are borrowed as per need Cost of borrowing and maturity of instruments is important

Considerations while Liability Management

Interest rate fluctuation may increase cost and thereby risk Sources and time period of borrowings to be taken into account

Applicability
Depends upon
Size of the bank Nature of operation of bank

For small size bank

Assets management is better option Major portion is retail deposit. Liquidity requirement is relatively low

For large size bank

Liability Management is better option

Technical Approach
Short term liquidity management Linked to cash flow arising due to operational transaction Bank should know its cash requirement and cash flow to ensure safe level of liquidity For this purpose there are two approaches
Working Fund Approach Cash Flow Approach

Working Fund Approach

It focus on actual cash position on factual data Working Funds includes
Owned Funds Deposits Float Funds

Owned Funds
Liquidity for owned funds is nil

Deposits
Liquidity requirement for deposits depends upon maturity profile of deposits Volatile funds
Current a/c, short term deposits 100 % liquidity is required

Vulnerable funds
Saving deposits Less than 100 % liquidity is required

Stable funds
Term deposits Least liquidity is required

Float Funds
Funds are in transit DD, BC, MT, TC etc 100 % liquidity is required

Assessing liquidity position on the basis of working fund

Decide average cash balance to be maintained as a % of working fund Decide range of acceptable variance If average balance is within this range liquidity is ensured If not corrective action is required
Either deploying surplus fund Or borrowing to meet the deficit

Cash Flow Approach

It takes into account potential increase or decrease in deposits / lending Trends can be established on the basis of historical data Planning horizon is to be decided

Basic steps in Cash Flow Approach

Estimate anticipated change in deposit Estimate cash inflow by loan recovery Estimate cash outflow by deposit withdrawal and loans Estimate liquidity need over the planning horizon Accurate forecasting & good data collection network is required for the success of this approach

Over

Exchange Risk Management

It is the risk that arises due to fluctuation in exchange rate Sale and purchase of foreign currency involves risk due to change in exchange rate Exchange rate changes due to change in demand and supply of foreign currency

Foreign exchange exposure

Foreign exchange exposure is the sensitivity of change in value of assets or liabilities or operating income to unanticipated changes in exchange rate Exposure is the absolute amount of money that is at risk Firm can set target for the level of exposure that they will be able to sustain

Types of exposure
Transaction exposure Translation exposure

Transaction exposure
Risk due to change in exchange rate at the time of execution of transaction and at the time of settlement Transaction exposure is because of Import / export Dividend paid / received in foreign currency Loan repayment made in foreign currency

Translation Exposure
This is relating to valuation of assets and liabilities and it arises while preparing consolidated balance sheet of a bank having branches, subsidiaries abroad Foreign currency assets and liabilities are valued at prevailing exchange rate Possibility of loss or gain Guidelines for valuation are issued by FEDAI and ICAI

Managing Exposure
Internal Technique
Netting Leading and Lagging Invoicing

External Technique
Forward Contract Currency Future Currency option Currency swap

Netting
Assets in foreign currency is used to pay liability No need for conversion Simultaneous occurrence of inflow and outflow in same currency and same amount is pre-condition EEFC account facility can be used

Leading and Lagging

Leading means advancing cash flow than due date Lagging means delaying cash flow beyond due date Conversion of currency can be avoided Consent of the counterparty is required

Invoicing
By making invoice in domestic currency conversion and exchange risk can be avoided Here the risk is transferred to counterparty

Forward Contract
Agreement to buy or sell foreign currency for
Pre-determined amount Pre-determined rate Pre-determined date

Counter party is a banker Bank normally covers the position Actual cash flow occurs at delivery

Currency Future
Similar to forward contract Difference is Here there is secondary market Future are traded on exchange Operations as per rules, regulation and guidelines issued by exchange Margin is required to be deposited with exchange

Currency Option
Buyer of an option has a right but not an obligation to buy or sell foreign currency Traded on exchange Standard size, maturity date Guidelines are issued by exchange

Currency Swap
It is useful to change composition of foreign currency assets and liabilities Used to exchange excess of one currency with other