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Iquidity Risk Management
Iquidity Risk Management
Liquidity is a banks ability to generate cash quickly at a reasonable cost. Liquidity risk is a risk
that a bank may fail to generate cash to meet liabilities and buy assets. This problem may affect
the banking system negatively. So, sound liquidity risk management is important for a bank.
Sources of liquidity risk:
A bank that plans expected liquidity requirements will structure the balance sheet accordingly
but sometimes there may be unexpected events which can have serious impact on banks
liquidity like fraud, natural disaster e.t.c. The following factors affect banks liquidity.
Access to financial markets: Larger banks have better access than the smaller banks which
may be credit worthy but with good track record and popularity.
Financial health of the banks: If a bank has poor asset quality then it will have low liquidity.
Balance sheets: Balance sheet also indicates the liquidity position. The most liquid banks will
have all its assets in cash or cash investments and the liabilities will be in stable deposits which
the bank can handle easily to face any liquidity problem
liability asset mix: Many banks invest in short term funds which allows short notice but if the
company needs more funds then it faces problems.
Timing of fund flow: The inflow and outflow of money occurs at different point of time which
cannot be seen in the balance sheets so the consequences of liquidity has a risk
Exposure to asset of balance sheet activities: Many banks make various commitments to the
customers which may lead to liquidity prices.
Impact of other risk: There is no single source for liquidity risk that other risk can also become a
liquidity problem like fluctuation in market interest rates affects banks investment portfolio.
Liquidity is the ability of a bank to fund increases in assets and meet obligations as they
come due without increasing unexpected losses.
2.
. The market turmoil that began in mid 2007 reemphasized the importance of liquidity to the
functioning of financial markets and the banking sector.
3.
4. In order to account for financial market development as well as turmoils the Basel committee
has conducted a fundamental review of its 2000 sound practices for managing liquidity in
banking organizations
Importance of establishing liquidity risk tolerance.
The maintenance of adequate level of liquidity, including through a cushion of liquid assets.
The necessity of allocating liquidity cost benefits and risks all significant business activities.
The identification measurement of fall range of liquidity risks including contingent liquidity risks.
Principle1:
A bank is responsible for the sound management of liquidity risk.
Principle2:
Bank should clearly articulate liquidity risk tolerance that is appropriate
for its business strategy and its role in financial system.
Principle 3:
The senior management should develop a strategy, policies and
practices to manage liquidity risk tolerance so that it has sufficient
liquidity.
Principle 4:
A bank must include liquidity cost, benefits and risk in the internal pricing
and other activities.
Principle 5:
A bank must have a large frame work to identify measure, monitor and
control liquidity risk and forecasting cash flow.
Principle 6:
Bank should monitor and control risk exposure and funding by
considering legal and operational limitation of the transferability.
Principle 7:
A bank must have a funding strategy for proper diversification.
Principle 8:
Bank should actively manage intraday liquidity position and payment risks.
Principle 9:
Bank should manage its collateral; monitor the legal position and physical location
of collateral.
Principle 10:
A bank should conduct stress tests to find sources of potential liquidity and
exposures according to tolerance.
Principle 11:
Bank should have proper contingency funding plan to manage liquidity shortage in
emergencies.
Principle 12:
A Bank should maintain high quality liquid assets as insurance during stress and
avoid any problem in using these assets for funding.
Liquidity risk is closely related to assets and liabilities of the banks and their investment and
financing decision so the banks must have two approaches to mange short term and long term
liquidity and this choice depends on the banks liquidity policy.
Liquidity policy:
It is different for different banks and also changes overtime situation or environment.
Approaches for liquidity management {long term}
Asset management approach:
Banks keep assets like money market instrument and marketable securities to get funds which
are available on the maturity, sale as use as collateral for borrowing but there is also default risk
or price volatility so bank keeps assets and also cash in hand but the cash is not profitable
where as assets give returns. Therefore management must balance liquidity and profitability by
evaluating the full return on liquid assets against the expected return of less liquid assets.
Liability management:
It focuses on sources of funds to prevent liquidity risk and investment of surplus funds in long
term assets. They use different strategies to manage liquidity risk like banks with large network
focus on low cost retailed deposits, if sale business then money market is preferred. The banks
must also have core and non core deposits but due to greater validity in core deposits leads the
banks depend on non core deposits. It benefits large, growth oriented aggressive banks in the
form of high returns but there are four risks:Sustaining high spreads which increases the cost and depends on market condition.
Asset liability risk: Long term loans require matching liabilities maturity.
Reinforcing risk
Reputation risk
Banks normally use some tools, forward looking retrospective to measure liquidity risk
Forward looking: it focuses on funding needs in future on daily, quarterly or half yearly.
Retrospective tools: study the historical behavior and make conclusions for future.
It includes banks capital and external liability. The liquidity is based on working funds available so banks
liquidity may be a proportion of the total working funds and second approach is classifying working funds
and maintain separate liquidity limit. For each class. The bank classifies its liabilities as own funds,
deposits and borrowings into volatile funds, vulnerable and stable funds.
The ratios approach: The banks use some ratios to manage liquidity risk which depends on their risk
profile eg of policies are:
It focuses at the medium term liquidity profile of a bank and how medium term assets are funded.
It focuses on predicting the cash flows of the bank. Over a period of and estimates liquidity needs and
then decides to invest surplus funds or borrow for investing in short term assets to have higher liquidity
and earn interest or invest in long term assets which can be use to borrow later.
It ignores the time value of money so the maturity period and the
basis does not clearly tell if there will be cash flow at the end or
not. So a banks gains or losses may be due to timing of repricing
and interest flows.
It ignores long term affect on fixed rate assets and liabilities.
It ignores the rate sensitivity if liabilities which carries no interest.
It does not record the differences in the sensitivity of income
arising from securities and deposits.
It ignores the time value of money so the maturity period and
basis does not clearly tell if there will be cash flow at the end or
not so banks gains or losses may be due to timing of repricing
and interest flows.
It ignores basic risk where loans are related to base rates which
is not easy to forecast in the market and leads to error.
It fails to consider changes in non interest revenue and expenses
due to fluctuation in interest rates
Maturity GAP provides only an approximate rule for analyzing interest rate risk
Duration GAP analysis matches cash flows and their repricing capabilities over a period of time.
The percentage change in value of portfolio gives a change in interest rates is proportional to
the duration of the portfolio multiplied by the change in interest rate.
DG=DA-{MVL/MVA} xDL
Dg= duration gap
Da= duration of assets
Dl= duration of liabilities
MVA= Market value of assets
MVL= Market value of liabilities
Duration GAPs are opposite in sign from maturity GAPs for the same risk exposure.
Positive duration GAP:
Assets have longer duration than liabilities, banks expects interest rate to fall
If the interest rate rise
a) More assets than liabilities will lose value
b) Thus reducing the value of the banks equity
IF the interest rate falls
a. More assets than liability will gain value
Certificate of deposit:
CD is short term borrowing in the form of promissory
notes having a maturity less than 7 days upto maximum
of one year.
Commercial paper:
Commercial paper is an unsecured money market
instrument issued in the form of promissory note.
Call money:
Call money exceeds one day {but less than15 days it is
referred to as notice money.
Treasury bill:
Treasury bill commonly referred to T-bill is issued by
government of India against their short term borrowing
requirements with maturities ranging between 14 to 364
days.