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Liquidity Risk Management

 

What is Liquidity Risk :

Liquidity risk is the potential inability to meet the liabilities as they become due.  It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities.

 

Importance of Liquidity Risk :

Measuring and managing liquidity needs are vital for effective operation of commercial banks.  By assuring a bank’s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing.

 

Liquidity Risk Management

Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also examining how funding requirements are likely to be affected under crisis scenarios. Net funding requirements are determined by analyzing the bank’s future cash flows based on assumptions of the future behavior of assets and liabilities that are classified into specified time buckets and then calculating the cumulative net flows over the time frame for liquidity assessment.

Future cash flows are to be analysed under “what if” scenarios so as to assess any significant positive / negative liquidity swings that could occur on a day-to-day basis and under bank specific and general market crisis scenarios. Factors to be taken into consideration while determining liquidity of the bank’s future stock of assets and liabilities include

• their potential marketability,

• the extent to which maturing assets /liability will be renewed,

• the acquisition of new assets / liability and

•  the normal growth in asset / liability accounts.

 Factors affecting the liquidity of assets and liabilities of the bank cannot always be forecast with precision. Hence they need to be reviewed frequently to determine their continuing validity, especially given the rapidity of change in financial markets.

The liquidity risk in banks manifest in different dimensions:

i)                           (a) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

                 (b)  Time Risk – need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

                 (c)  Call Risk – due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

 

How is it measured :

Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches.  The key ratios, adopted across the banking system are

•  Loans to Total Assets,

• Loans to Core Deposits,

• Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments,

• Purchased Funds to Total Assets,

• Loan Losses/Net Loans,

However, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market.  Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional.

Thus, analysis of liquidity involves tracking of cash flow mismatches.  For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool.

The following prudential limits are considered by Banks to  put in place  to avoid liquidity crisis:-

i)       (i) Cap on inter-bank borrowings, especially call borrowings; ii)     Purchased funds vis-à-vis liquid assets;  iii)  Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans;  iv)    Duration of liabilities and investment portfolio;   v)      Maximum Cumulative Outflows across all time bands;  vi)    Commitment Ratio – track the total commitments given to corporates / banks and other financial institutions to limit the off-balance sheet exposure; vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

 

 

BCBS Principles for the Assessment of Liquidity  Management in Banks

 

 

Developing a Structure for Managing Liquidity

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. The board should also ensure that senior management takes the steps necessary to monitor and control liquidity risk. The board should be informed regularly of the liquidity situation of the bank and immediately if there are any material changes in the bank’s current or prospective liquidity position.

Principle 3: Each bank should have a management structure in place to execute effectively the liquidity strategy. This structure should include the ongoing involvement of members of senior management. Senior management must ensure that liquidity is effectively managed, and that appropriate policies and procedures are established to control and limit liquidity risk. 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 information systems for measuring, monitoring, controlling and reporting liquidity risk. Reports should be provided on a timely basis to the bank’s board of directors, senior management and other appropriate personnel.

 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.

 

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.

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.

 Foreign Currency Liquidity Management

Principle 10: Each bank should have a measurement, monitoring and control system for its liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually.

 Principle 11: Subject to the analysis undertaken according to Principle 10, a bank should, where appropriate, 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.

 

Internal Controls for Liquidity Risk Management

Principle 12: Each bank must have an adequate system of internal controls over its liquidity risk management process. A fundamental component of the internal control system involves regular independent reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that appropriate revisions or enhancements to internal controls are made. The results of such reviews should be available to supervisory authorities.

 

Role of Public Disclosure in Improving Liquidity

Principle 13: Each bank should have in place a mechanism for ensuring that there is an adequate level of disclosure of information about the bank in order to manage public perception of the organisation and its soundness.