Liquidity Risk

The liquidity risk of banks arises from funding of long-term assets by short-
term liabilities, thereby making the liabilities subject to rollover or
refinancing risk.
Dimensions
(i) Funding Risk- it is the need to replace net outflows due to unanticipated
withdrawal/non-renewal of deposits ( wholesale and retail);
(ii) Time Risk – It is the need to compensate for non-receipt of expected
inflows of funds, i.e., performing assets turning into non-performing
assets; and
(iii)Call Risk-it happens on account of crystallization of contingent liabilities
and unable to undertake profitable business opportunities when desired.

Principles
Principle 1: Each bank should have an agreed strategy for the day to day
management of liquidity. This strategy should be communicated
throughout the organisation.
Principle 2: A bank’s Board of Directors should approve the strategy and
significant policies related to the management of liquidity.
Principle 3: Each bank should have a management structure in place to
execute effectively the liquidity strategy.
Principle 4: A bank must have adequate information systems for measuring
monitoring, controlling, and reporting liquidity risk.
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 analyze liquidity utilizing a variety of “what if”
scenarios.
Principle 7: A bank should review frequently the assumptions utilized in
managing liquidity to determine that they continue to be valid.
Managing Market Access:
Principle 8: Each bank should periodically review its efforts to establish and
maintain relationship with liability holders, to maintain the diversification of
liablities, and aim to ensure its capacity to sell assets.
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.
Principle 10: Each bank should have a measurement, monitoring and
control system for its liquidity positions in the major currencies.
Principle 11: A bank should, were appropriate, set and regularly review
limits on the size of its cash flow mismatches.
Principle12: Each bank must have an adequate system of internal
controls over its liquidity risk management process.
Liquidity Risk Management :
The key ratios, adopted across the banking system are:
• Loan to Total Assets;
• Loans to Core Deposits;
•Large Liabilities (minus) Temporary Investments to Earning Assets (minus)
Temporary Investments, where large liabilities represent wholesale deposits
which are market sensitive and temporary investment which are held in the
trading book and are held in the trading book and are readily sold in the
market;
• Purchased Funds to Total Assets, where purchased funds include the
entire inter-bank and other money market borrowings, including Certificate
of Deposits and institutional deposits;
Alternative – Scenarios:
The liquidity profile of banks depends on the market conditions, which
influence the cash behaviour. Thus, banks should evaluate liquidity profile
under different conditions, normal situation, bank specific crisis and market
crisis scenario.
Contingency Funding Plan
Banks should prepare contingency plans to measure their ability to
withstand bank-specific crisis specific or market crisis scenario. As per
the Guidance Note on Market Risk Management, these plans are to be
prepared by the ALCO, submitted annually as part of the liquidity and
Capital Plan, and reviewed quarterly. Contingency Funding Plans are
liquidity stress tests designed to quantity the likely impact of an event
on the balance sheet and the net potential cumulative gap over a 3
month period.
Liquidity Gap and Liquidity Management
Liquidity risk management can be studied broadly under two methods:
(i) Static Approach-Ratio Analysis
(ii) Dynamic liquidity Analysis.
Volatile Liability Dependence Ratio:

Volatile Liabilities-Temporary Investments

VLDR = -------------------------------------------------------------------
Net Loans + Investments due in more than a year
This ratio shows the extent to which the bank is relying on volatile funds to
support long a term assets. The volatile liability dependence ratio fluctuates
with the size of the bank. This ratio can also be negative. For instance, if the
ratio is negative 20%, it signifies that the bank can increase its long-term
commitments up to 20% by drawing from core deposits.
In Indian context, at present foreign banks and new generation private sector
banks have a higher dependency on volatile liabilities, which also adds to
their cost of funds.
Core Deposit Growth Rate
The ratio is calculated as under:
Core Deposit Growth
CRGR = ------------------------------
Asset Growth

Asset Growth
This ratio shows how much asset growth was funded by core deposit
growth. The higher the ratio the better will be the position. If asset growth is
not funded by given deposit growth, then it is being funded primarily by
volatile liabilities or equity capital.
The other important ratios which measure liquidity stored in the balance
sheet are as follows:
• Loans / Assets
• Loans /Core Deposits
• Purchased funds /Total Assets.
• Risk Assets/ Total Assets
• Loan Losses /Net Loans.
Dynamic Liquidity Analysis
Dynamic Liquidity analysis is also known as the cash flow approach
represents dynamic measurement of liquidity requirements. It provides for
appropriate tools for assessing the day-to-day liquidity needs of the
financial institution.
Structural Liquidity: The methodology for studying the liquidity
requirements involve preparing a statement of structural liquidity by taking
into account the balance sheet as on a particular date. The balance sheet
items are placed in the maturity ladder according to the time buckets which
are related to the expected timing of cash flows.
Short-Term Dynamic Liquidity: The structural liquidity ladder takes into
account only the balance sheet items in eight maturity buckets and does
not recognize any future business growth entailing additional Outflows and
inflows.
Control Mechanism
The negative gaps in individual time buckets are sought to be controlled by
placing, prudential limits on the basis of business Structure and financial
flexibility of the individual banks. In the Indian context, RBI has placed a
prudential limit of 20% of outflows in the first two time buckets viz. 1 to 14
days and 15 to 28 days. In case the negative gap exceeds the prudential
limit of 20% of outflows, the bank needs to indicates as to how it proposes
to finance the gap to bring the mismatch with prescribed limits. The gap
can be financed from market borrowings, bills rediscounting, REPOs, and
deployment of foreign currency resources after conversion into rupees.