Chapter 4 – Liquidity Management

Chapter 4 – Liquidity Management

Banks need liquidity to meet deposit withdrawals and to fund loan demands. The variability of loan demand and the variability of deposits determine a bank’s liquidity needs.

Effective liquidity management helps in :

1. Demonstrating that the bank has the capacity to repay its borrowings.
2. Meeting prior loan commitments towards its borrowers
3. Avoiding the unprofitable sale of its assets for meeting the urgent liquidity requirements
4. Decreasing the default risk premium, as a bank with a strong balance sheet is perceived to be liquid and safe due to which it can raise funds at lower premium.

Parameters for assessing the adequacy of liquidity position of the bank

1. Historical funding requirements
2. Current liquidity position
3. Expected funding needs for future
4. Source of funds
5. Options available to decrease the funding requirements
6. Asset quality — present and anticipated
7. Earning capacity — present and future
8. Present and planned capital position

Factors affecting the liquidity position of a bank:

1. Decline in profits
2. Increase in NPAs
3. Deposit concentration
4. Downgrading of the bank by rating agencies
5. Expanded business opportunities
6. Acquisitions
7. New tax initiatives

How can a bank provide funds for its requirement

1. Sale of liquid assets
2. Sale of less liquid assets
3. Increase in short term borrowings
4. Increase in long term liabilities
5. Increase in capital funds

Liquidity Risks

Risk can be internal, external or of other category:

1. Internal risk — These risks are institution specific. These are as per perception of a bank in respect of various market segments such as local market, regional market, national market and international market.
2. External risk —These risks are geographic risks, systemic risks or product specific risk
3. Other risks — These include funding risk, time risk and call risk
   1. Funding risk stands for need to replace the net outflow of funds due to unanticipated withdrawals or non-renewal of deposits as a result of frauds causing substantial loss, systemic risk, loss of confidence of the clients or liabilities in foreign exchange.
   2. Time risk stands for need to compensate for non-receipt of anticipated inflows of funds as a result of deterioration in the asset quality, loan account becoming NPA, temporary problem in recovery of loans
   3. Call risk stands for crystallization of contingent liabilities or inability to undertake profitable business opportunities when desirable as a result of conversion of non-fund based limits into fund based. Popular Bank faced a no. of internal and external frauds recently due to which (a) it has not been able to make payment of its liabilities. (b) In addition, due to this fraud, the confidence of the customers has shaken and resultantly, they have started withdrawing their deposit or have resorted to non-renewal of maturing term deposits. (c) Due to bank’s failure to make certain payment that are due to other banks, those banks have not been able to meet their obligations.

Measurement and Management of Liquidity-Risk

Action points for management of liquidity risk There are three steps

(a) Developing a structure for management of liquidity risk

(b) Setting Tolerance limits

(c) Measuring and Management of liquidity risk.

1. Structure for management of liquidity risk

• Bank should have liquidity management structure to formulate liquidity strategy, policies and procedures.
• All financial transactions have effect on bank’s liquidity. Hence the strategy of liquidity management should be communicated to all levels and all business units of the organization, that conduct activities affecting liquidity.
• Board has to monitor the liquidity risk profile of the bank and periodically review the information.

2. Tolerance levels and limits for liquidity risk Banks are required to set and review the limits for various activities, with a view to ensure liquidity, which include

• Cumulative cash flow mismatch i.e. cumulative net funding as a %age of total liabilities
• Liquid assets as a %age of short term liabilities
• Loan to deposit ratio
• Loan to capital ratio
• Anticipated funding needs and available sources for meeting those needs
• Reliance on a particular liability category as a %age of total liabilities.

3. Measuring and managing liquidity risk There are two approaches to measure and manage funding requirements (a) stock approach (b) flow approach):

• Stock approach It is based on the level of assets and liabilities and also the off-balance sheet exposures on a particular date.
• Flow approach.: The Indian banks mainly follow this approach which is a basic approach. It is blown as gap method. It has three main dimensions (a) measuring and managing net funding requirements (b) managing market accesses (c) contingency planning.
  • Measuring and managing net funding requirement: In this method structural liquidity gap report is prepared
  • The net funding requirement is calculated on the basis of residual maturities of assets and liabilities.
  • The residual maturities represent the net cash flow i.e. difference of outflow and inflow of cash in future time bucket.
  • Cumulative gap is calculated for various time buckets, which shows the cash outflow and inflow difference at a particular time, say week, fortnight, month, quarter, half-Year or year.
  • Where the gap is negative, the bank has to manage the shortfall.

The net funding requirements of a bank can be determined by analyzing the future cash flows based on assumptions of future behaviour of assets, liabilities and off-balance sheet items and thereafter calculating the cumulative net excess over the time fiarne for the liquidity assessment. These aspects can be explained through the concept of (a) maturity ladder (b) alternative scenarios (c) measurement of liquidity over the chosen time frame and (d) assumptions used in determining cash flows.

1. Maturity ladder : It is prepared by placing the sources and cash inflows on the one side and uses and outflows on the other side. It is used to compare a bank’s future cash inflows and cash outflows position over a series of specified time periods. The ladder can be prepared for one day, one week or for a longer period. The difference between cash inflows and the cash outflows in each period, the excess of deficit of funds, becomes a starting point for a measure of future liquidity excess or shortfall, at a series of points in time. This net funding requires management. If these funding gaps are there in distant future time, these can be managed by influencing the maturity of future transactions. But if these are in short future time, the management becomes difficult because the maturity of transactions cannot be influenced easily.
2. Alternative scenarios: This involves making of assessment of liquidity in different conditions, which may be (a) Normal market conditions (b) bank specific crisis (c) general market crisis,
   1. Normal market conditions : This scenario is useful in managing use of deposit and other debt instruments. It provides a benchmark and by taking into account this benchmark, the bank can manage its funding requirement to avoid impact of temporary constraints.
   2. Bank specific crisis : This scenario may emerge when the liabilities can not be rolled over and have to be paid, while the maturing assets could not be realized on due date. Preparation of scenario with a worst-position can help a bank to prepare for the situation, if emerges.
   3. General market crisis : This scenario is prepared where the liquidity is affecting all the banks due to which they are failing to meet their commitments. The central bank may find such scenario useful to examine the liquidity profile of the banking system.
3. Measurement of liquidity over the chosen time frame: The liquidity profile of a bank can be tabulated graphically for several time points with a view to provide insight into bank’s liquidity and to check as to how consistent and realistic, the assumptions are for a specific bank. it is possible that a well managed bank may appear very liquid in normal market condition and marginally liquid in a bank specific crisis and quite liquid in market crisis condition.
4. Assumptions used in determining cash flows: The planning for liquidity risk, done for future, takes into account certain assumptions that are required to be reviewed. These assumptions are to be made with reference to (a) assets (b) liabilities (c) off-balance sheet activities and (d) others.
   1. Assumptions regarding assets : Assumptions about assets include their future marketability and use of existing assets as collateral, to enhance the cash inflows. This will further take into account (a) the roll over possibilities of the assets on maturity, (b) potential for creation of new loan assets, (c) funding of expected drawdown of commitments to lend. To determine the marketability of assets, the assets can be segregated into (a) most liquid category such as cash, interbank loans, securities, (b) less liquid category such as saleable loan portfolio and (c) least liquid category such as non-saleable loans, bank premises, investments in subsidiaries etc.
   2. Assumptions regarding liabilities: Assumptions regarding liabilities can be made taking into account the behaviour of bank’s liabilities in normal circumstances i.e. level of roll over of deposits, effective maturity of demand deposits and normal growth of deposits.
      1. Further the bank will have to examine as to (a) which funds are likely to stay with bank in crisis situation, (b) which shall be gradually withdrawn and (c) which shall be withdrawn. immediately and (d) what drawdown support is available.
      2. The funds under (a) category shall be available along with the capital and reserves in all circumstances and provide support. Funds under (b) category shall stay in case of mild crisis situation.
   3. Assumptions regarding off-balance sheet activities: These assumptions have to take into account the possibility of crystallization of non-fund based credit facilities such as letter of credit. and bank guarantees although they are not dependent on condition of the bank. But a general market crisis may create situations where due to increase in defaults by the constituents, there are demands to encash the non-fund based facilities by the beneficiaries.
   4. Other assumptions: In addition to the above, normal business related activities, the banks undertake other activities such as payment services to other bank. These activities may result in cash outflows. Contingency plan:

Ability of a bank to meet the liquidity .crisis would depend upon the contingency plan of a bank. An effective contingency plan takes into account the following:

• Procedures for information inflow.
• Clear division of responsibility
• Action points for altering the asset and liability
• Maintaining customer relationship with borrowers and depositors
• Procedure for making up cash flow shortfalls in emergency situations
• Liaison with press and broadcast media