Liquidity Risk Management

&
Cost of Funds

Maneesh Raj
 Agenda
 Liquidity Risk
 Understanding Liquidity & Liquidity Risk
 Liquidity Needs Estimation
 Liquidity Risk Management
 BCSB Principles Relating to LRM in Banks
 Cost of Funds
 Basic Concepts & Components
 PLR & Base Rates
Understanding Liquidity & Liquidity Risks in Banks
 Object of ALM Policy
• Ensuring Profitability
• Ensuring Liquidity
Banks borrow ‘short’ and lend ‘long’

This ensures ‘price matching’ but may lead to

‘liquidity mismatch’
Management of Liquidity Risk and Interest Rate
Risk go hand-in-hand but with a difference in
approach.
 Cash Assets of Banks
• Banks own four types of cash assets :
- Vault Cash
- Demand Deposit Balances with RBI
- Demand Deposit Balances with Other FIs
- Cash Items in the Process of Collection(Float)

Why do Banks hold Cash ?

 Why do Banks hold Cash ?
• Enable customers to do regular transactions
• To meet mandates of Regulators
• To serve nation’s Check Payment System
• To purchase services from correspondent banks
However, Cash Assets do not generally

satisfy a Bank’s Liquidity Needs

 What is Liquidity ?
Qualities of a Liquid Asset

Can convert to cash quickly

Low transaction cost to liquidate
Does not move the market upon conversion
 Two Facets of Liquidity ?
• Market Liquidity :
 easy to trade / low bid-ask spread
 small price-impact
 easy search / adequately available

• Funding Liquidity :
 funding from own capital
 funding from collateralized loans
 funding from “Market”
 So, what is Liquidity Risk ?
• Market Liquidity Risk:
- Risk that the market liquidity worsens when
you like to trade

• Funding Liquidity Risk:

- Risk that a trader cannot fund his position
and is “forced” to unwind
 Liquidity – Credit – Interest Rate Risk

Mismatched A/L maturities & Durations or by

Poor Liquidity
extending credit to high risk borrowers

Further Decline / Reduced Margins / High NPA / Reduced

non accruing loans / spiral effect earnings

Higher Rates to attract deposits / Negative Outlook in

funds Market
 Liquidity Versus Profitability
• There is a short-run trade off between
Liquidity and Profitability.
• Both Asset & Liability Liquidity contribute to
this trade-off.
Liquidity Needs Measurement
 Estimation of Liquidity
1. Sources and Uses of Funds Method
• Loan compartments made • Sources and Uses of funds
• Based on historic al trends,
future flows are estimated are studied / estimated
• Economic levels are also • “Maturity Ladders” are
factored in constructed
• Cyclic trends are established • Market access designed
• Contingency plans drawn
 Estimation of Liquidity
2. Structure of Deposit Method
• List all types of deposits at the bank
• Assign “probability of withdrawal”
• Arrive at withdrawable fund in planning horizon
Deposit Type Amount Held Probability Of Withdrawals
(Rs 000 Cr) withdrawal
Demand Deposits 5 0.90 4.50
Other Demand Deposits 10 0.70 7.00
Savings Deposits 100 0.40 40.00
Term Deposits 50 0.20 2.00
Expected Deposit Withdrawals 53.50
 Liquidity of Future Stocks
Considerations while determining liquidity of the bank’s
future stock of assets & liabilities

• their potential marketability,

• the extent to which maturing asset /liability
will be renewed,
• the acquisition of new asset / liability and
•  the normal growth in asset / liability accounts
 Liquidity Risk Ratios
• Loans to Total Deposits
• Loans to Non Deposit Liabilities
• Loans to Core Deposits
• Unencumbered Liquid Assets/nondeposit liab.
• Purchased Funds to Total Assets
• Loan Losses / Net Loans (Net NPA %)
 Asset Liquidity Measures
• Cash & Dues from Banks
• Due from Banks
• Treasury Securities
• Corporate Obligations – maturing before 1 yr
• Loans - easily sold / securitized
Liquidity Risk Management
 Development of Liquidity Concept
• Short term self-liquidating loans (prior to 1930)
• Shiftability Theory (1930-1950)
• Anticipated Income Theory (1950)
• Liability Management Theory

Now banks use comprehensive ALM to meet

its Liquidity requirements.
 Levels of LR Management
• Day-to-Day (up to a week)
• Ongoing Cash flow Mgmt (up to 3 months)
• Structural Liquidity (up to five years)

Catastrophic / Stress Liquidity Mgmt

Approaches - Liquidity Risk Management

• Fundamental Approach
• Technical Approach

Though the two methods distinguish

strategically, they supplement each other.
 Fundamental Approach (1/3)
“ Liquidity can be imparted in the system either
by Liability Creation or by Asset Liquidation.”
Asset Management :

- Aims to eliminate liquidity risk by holding near cash assets

- Primary Assets will be the second to be utilized
- Secondary Line of Defense : Unsecured Marketable Sec.
 Fundamental Approach (2/3)
Liability Management

- focuses on the sources of funds

- bank doesn’t maintain any surplus of funds
- adheres to raising funds whenever so required
Asset Management Strategy emphasizes on the best
deployment of funds , whereas Liability
Management tries to achieve the same through
mobilizing Additional funds.
 Fundamental Approach (3/3)
Asset Liquidity Management
• Historically, primary means
• Involves instantaneous
generation of liquidity by
assets-liquidation
• Liquid Assets plays 2 roles :
1. Alternative source of funds
2. Acts as Secondary Reserves
It also boosts investors
confidence in the bank.
Liability Liquidity Management
• Newer Concept
• Involves acquisition of
external funds when liquidity
needs arises
• Assets can be shifted from
high earning instruments
• Greater Asset diversification
Enhances: Interest Rate,
Capital Mkt & Financial
Risks
 Technical Approach
• Focus is on Cash Flows Position
• Working Funds Approach
- Volatile funds
- Vulnerable funds
- Stable funds
• Cash Flows Approach
 Working Funds Approach (1/4)
• Working Funds = owned + deposits + float
• Liquidity requirements for each component is
assessed (consolidated or segmented)

Component Liquidity Nature

- Owned (capital) Nil
- Deposits Variable
- Float Variable
 Working Funds Approach (2/4)
• Deposits
Nature Liquidity Required
- Volatile 100 %
- Vulnerable < 100 %, depends on policy
- Stable lower, ----- do ------
• Floats
- Similar to Deposits, mix of stable & variable
 Working Funds Approach (3/4)
Flow of Working Funds Approach

Components of Working Funds

Determine Objective

Lay down the range of variance Collect Historical Data

Lay down the Avg Cash & bank balances to be

maintained as % of total Working Funds

 Working Funds Approach (4/4)
Limitations of the Approach

• Classifying deposits is a subjective decision

• Ignores potential deposits / flows

 Cash Flows Approach (1/4)

Important Parameters :

- Planning horizon for the forecasts

- Cost Involved in forecasting

 Cash Flows Approach (1/4)
Flow of Working Funds Approach

Determine Planning horizon of forecast

Estimate Liquidity Required Estimate Anticipated

changes in deposits

Forecast on historical trends Estimate cash inflows by recovery

Estimate the cash outflows : by deposit

withdrawals & Credit accommodations
 Liquidity Gap Report
Steps in Preparing a Gap Report

 Determine the number of time buckets

 Determine the length of each bucket
 Slot every asset, liability and off balance sheet
item into a corresponding bucket
 Compute the gap
 Compute the cumulative gap and other related
measures
 Liquidity Gap Report
• Under normal business conditions or going
concern scenarios.
• Under bank or organization specific problems
(such as inability to roll-over its deposits or
withdrawal of deposits before maturity).
• Under general crises conditions (such as bank
may not be able to raise funds from disposal of
near liquid assets such as marketable securities).
 Other Related Concepts
• Liquidity Planning Vs Reserve Requirements
• Managing Floats (BoNY, Nov 20,1985)
• Managing Correspondent Balances
• Securitization as provider of liquidity

• LAF (Liquidity Adjustment Facility) of RBI

BCSB Principles for the Assessment of
Liquidity  Management in Banks
 BCSB Principles for the Assessment of Liquidity  Management in Banks
 

• Developing a Structure for Managing Liquidity

• Measuring and Monitoring Net Funding
Requirements
• Managing Market Access
• Contingency Planning
• Foreign Currency Liquidity Management
• Internal Controls for Liquidity Risk Management
• Role of Public Disclosure in Improving Liquidity
 BCSB Principles
Developing a Structure for Managing Liquidity

• Principle 1 : Adopt an agreed strategy for the day-to-day management of

liquidity.

• Principle 2: Board of directors to approve the strategy and significant

policies related to the management of liquidity. The board should also
ensure that senior management takes the steps necessary to monitor and
control liquidity risk.

• Principle 3: Each bank should have a management structure in place to

execute effectively the liquidity strategy. Banks should set and regularly
review limits on the size of their liquidity positions over particular time
horizons.

• Principle 4: A bank must have adequate & timely information systems for
measuring, monitoring, controlling and reporting liquidity risk.
 BCSB Principles
Measuring and Monitoring Net Funding Requirements

• Principle 5: Each bank should establish a process for the

ongoing measurement and monitoring of net funding
requirements.

•  Principle 6: A bank should analyse liquidity utilising a variety

of “what if” scenarios.

•  Principle 7: A bank should review frequently the assumptions

utilised in managing liquidity to determine that they continue
to be valid.
 BCSB Principles
Managing Market Access

Principle 8: Each bank should periodically review its

efforts to establish and maintain relationships with
liability holders, to maintain the diversification of
liabilities, and aim to ensure its capacity to sell assets
 BCSB Principles
Contingency Planning

Principle 9: A bank should have contingency plans in

place that address the strategy for handling liquidity
crises and include procedures for making up cash
flow shortfalls in emergency situations.
 BCSB Principles
Foreign Currency Liquidity Management
• Principle 10:
- Measurement, monitoring and control system for its liquidity
positions in the major currencies in which it is active.
- A bank should also undertake separate analysis of its
strategy for each currency individually.

•  Principle 11: Set and regularly review limits on the size of its
cash flow mismatches over particular time horizons for
foreign currencies in aggregate and for each significant
individual currency in which the bank operates.
 
 BCSB Principles
Internal Controls for Liquidity Risk Management

Principle 12:
• Develop adequate system of internal controls over its
liquidity risk management process.
• Regular independent reviews and evaluations of the
effectiveness of the system and
• The results of such reviews should be available to
supervisory authorities
Measuring Cost of Funds
 3-6-3 Method to Run a Bank
• In highly regulated banking environment worldwide :
- Liability Management was routine
- Customers had hardly any choice
- Customers were loyal

So, the Golden Rule was :

Pay 3 % on deposits, charge 6 % on loans and hit
the golf course at 3 o’clock
 Major Components
• Cost of acquiring funds
• Cost of admin. Overheads & Operational costs
• Cost attached with making loans
• Costs attributable to Risk factors
• Related Considerations (profitability goals etc)
 Methods of Computing Cost of Funds
Average Cost of Funds

• Average Cost of Funds

• Marginal Cost of Funds
• Match Funding
 Methods of Computing Cost of Funds
1. Average Cost of Funds

• Avg historical costs are taken for pricing

decisions
• Historical interest expenses are clubbed with
non-interest expenses
• They don’t take future costs into consideration
• Theory assumes that the interest rate will be
constant at historical levels
 Methods of Computing Cost of Funds
2. Marginal Cost of funds

- A measure of borrowing cost to acquire one

additional unit of investable funds

- Rising Rate : Marginal Cost > Historical costs

Falling Rate : Marginal Cost < Historical Costs

- Marginal Cost = ( forecasted Interest Rate + Servicing

Cost + Acquisition cost + Insurance) / (1-% of funds in
nonearning assets)
 Sources of funds & their costs

• Owned Capital :
Direct Cost :
Opportunity Cost : say, 8.00 %

• Reserve Requirements
Present C.R.R. : 6.00 %
Opportunity Cost : 0.50 %
6.50 %
 Sources of funds & their costs
• Deposits

Current Accounts : Nil, but highly volatile

Savings Accounts : 3.50 %
Term Deposits : Market determined

• Deposits Insurance

Premium Charged : 1.25 %

 Sources of funds & their costs
• Borrowals :
- From RBI : Repo Auction : 5.25 %
- Call Money : 4.00 %
- Money Market Borrowal: say, 5-6 %
 Sources of funds & their costs
• Costs on Bad Debts:
- Provisions
- Capital Charges
- Carry Costs
- Opportunity Costs
- Higher Risk Premium
Calculate : Weighted Avg Cost of all items
Add : Risk Premium
Add : Administrative & Operational costs
 A Typical Risk-based Pricing
15%

14% 13.6%
14.2%
12.8%
13% 12.3%
11.8%
12%
11.0%
10.7% 11.0%
11%
Cost and Pricing

10.2%
10.25% [PLR]
10%
9.3%
Risk Prem ium
9%
8.1%
8% 7.5%

7%
Costs = 7.3%
6%
SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8
Cost of funds Costs + Premium PLR Existing Pricing
 A Typical Risk-based Pricing
17%

16%
15.0% 15.6%
15%

14%
12.8%
13% 12.3% 12.4%
11.8% 12.1%
Cost and Pricing

12% 11.5%
11.0%
11% 10.7% Spread
10.25% [PLR]
10% 9.5%
8.9%
9% Risk Prem ium

8%

7% Costs = 7.3%
6%
SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8

Cost of funds Costs + Prem ium Proposed Pricing

PLR Existing Pricing
 BPLR Vs Base Rate ?
Base Rate will include
• the card interest rate on retail deposit - deposits below
Rs. 15 lakh with one year maturity - adjusted for CASA
deposits
• adjustment for the negative carry in respect of CRR and
SLR
• unallocated overhead cost for banks which would
comprise a minimum set of overhead cost elements
• average return on net worth.
Thank You !
 Depositor’s Panic - Incidences
• April 13,2003 : ICICI, Rs 250 Cr withdrawal ; RBI
came defending ICICI’s strength
• Feb. 11, 2002 : Bank of Punjab
• 2002 : Many cooperative banks were run.
Ex : General Cooperative Bank (Gujarat)
Suryapur Cooperative Bank (Surat)
Diamond Jubilee Bank (Surat)
• Nov 20, 1985
Bank of New York, a $ 16 bn firm, finds that the bank was deficient in
its required reserve holdings by $ 23.60 bn.

• 1984 : Continental Illinois Bank

• 1991 : Bank of New England

• 2007-08 : During Subprime Crisis, Liquidity Crunch was one of the

most major factors