Chapter 7 – Liquidity Risk Management
Bank liquidity or liquidity means the ability of a bank to accommodate decline in liability and to fund increase in assets. when a bank is able to get sufficient funds by increasing liabilities or by converting its assets quickly, it is said that the bank has adequate liquidity. Liquidity problems arise on account of the mismatches in the timing of inflows and outflows.
Potential Liquidity Risk Drivers
The internal and external factors in banks that may potentially lead to liquidity risk problems in Banks
- Internal Banking Factors
- High off-balance sheet exposure
- The bank rely heavily on the short-term corporate
- A negative gap (liability is more than asset) in the maturity dates of assets and liability
- The banks’ rapid asset expansions exceed the available funds on the liability side
- Concentration of deposit in the short term tenor
- Less allocation in the liquid government instruments
- Fewer placement of funds in long-term deposits
- External Banking Factors
- Very sensitive financial markets depositors
- External and internal economics shocks
- Low/slow economic performances
- Decrease depositors’ trust on the banking sector
- Non-economic factors
- Sudden and massive liquidity withdrawals from depositors
- Unplanned termination of government deposits
Types of Liquidity Risk
Banks face the following types of liquidity risk:
(i) Funding Liquidity Risk – the risk that a bank will not be able to meet efficiently the expected and unexpected current and future cash flows and collateral needs without affecting either it daily operations or its financial condition.
(ii) Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption.
Governance of Liquidity Risk Management
The Reserve Bank had issued guidelines on Asset Liability Management (ALM) system, covering inter alia liquidity risk management system, in February 1999 and October 2007. Successful implementation of any risk management process has to emanate from the top management in the bank with the demonstration of its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organisational set up for liquidity risk management should be as under:
- The Board of Directors (BoD)
The BoD should have the overall responsibility for management of liquidity risk. The Board should decide the strategy, policies and procedures of the bank to manage liquidity risk in accordance with the liquidity risk tolerance/limits as detailed in paragraph 14. The risk tolerance should be clearly understood at all levels of management. The Board should also ensure that it understands the nature of the liquidity risk of the bank including liquidity risk profile of all branches, subsidiaries and associates (both domestic and overseas), periodically reviews information necessary to maintain this understanding, establishes executive-level lines of authority and responsibility for managing the bank’s liquidity risk, enforces management’s duties to identify, measure, monitor, and manage liquidity risk and formulates/reviews the contingent funding plan.
- The Risk Management Committee:
The Risk Management Committee, which reports to the Board, consisting of Chief Executive Officer (CEO)/Chairman and Managing Director (CMD) and heads of credit, market and operational risk
management committee should be responsible for evaluating the overall risks faced by the bank including liquidity risk. The potential interaction of liquidity risk with other risks should also be included in the risks addressed by the risk management committee.
- The Asset-Liability Management Committee (ALCO):
The Asset-Liability Management Committee (ALCO) consisting of the bank’s top management should be responsible for ensuring adherence to the risk tolerance/limits set by the Board as well as implementing the liquidity risk management strategy of the bank in line with bank’s decided risk management objectives and risk tolerance.
- The Asset Liability Management (ALM) Support Group:
The ALM Support Group consisting of operating staff should be responsible for analysing, monitoring and reporting the liquidity risk profile to the ALCO. The group should also prepare forecasts (simulations) showing the effect of various possible changes in market conditions on the bank’s liquidity position and recommend action needed to be taken to maintain the liquidity position/adhere to bank’s internal limits.
Liquidity Risk Management Policy, Strategies and Practices
The first step towards liquidity management is to put in place an effective liquidity risk management policy, which inter alia, should spell out the liquidity risk tolerance, funding strategies, prudential limits, system for measuring, assessing and reporting/reviewing liquidity, framework for stress testing, liquidity planning under alternative scenarios/formal contingent funding plan, nature and frequency of management reporting, periodical review of assumptions used in liquidity projection, etc. The policy should also address liquidity separately for individual ventures and associates, and business lines, when appropriate and material, and should place limit to transfer of liquidity keeping in view the regulatory, legal and operational constraints.
The Board of Directors or its delegated committee of Board members should oversee the establishment and approval of policies, strategies and procedures to manage liquidity risk, and review them at least annually.
Liquidity Risk Tolerance
Banks should have an explicit liquidity risk tolerance set by the Board of Directors. The risk tolerance should define the level of liquidity risk that the bank is willing to assume, and should reflect the bank’s financial condition and funding capacity, The tolerance should ensure that the bank manages its liquidity in normal times in such a way that it is able to withstand a prolonged period of, both institution specific and market wide stress events. The risk tolerance articulation by a bank should be explicit, comprehensive and appropriate as per its complexity, business mix, liquidity risk profile and systemic significance.
They may also be subject to sensitivity analysis. The risk tolerance could be specified by way of fixing the tolerance levels for various maturities under flow approach depending upon the bank’s liquidity risk profile as also for various ratios under stock approach. Risk tolerance may also be expressed in terms of minimum survival horizons (without Central Bank or Government intervention) under a range of severe but plausible stress scenarios, chosen to reflect the particular vulnerabilities of the bank. The key assumptions may be subjected to a periodic review by the Board.
Strategy for Managing Liquidity Risk
The strategy for managing liquidity risk should be appropriate for the nature, scale and complexity of a bank’s activities. In formulating the strategy, banks/banking groups should take into consideration its legal structures, key business lines, the breadth and diversity of markets, products, jurisdictions in which they operate and home and host country regulatory requirements, etc. Strategies should identify primary sources of funding for meeting daily operating cash outflows, as well as expected and unexpected cash flow fluctuations.
MANAGEMENT OF LIQUIDITY RISK
A bank should have a sound process for identifying, measuring, monitoring and mitigating liquidity risk as enumerated below:
Identification
A bank should define and identify the liquidity risk to which it is exposed for each major on and off balance sheet position, including the effect of embedded options and other contingent exposures that may affect the bank’s sources and uses of funds and for all currencies in which a bank is active.
Measurement of Liquidity Risk
There are two simple ways of measuring liquidity; one is the stock approach and the other, flow approach. The stock approach is the first step in evaluating liquidity. Under this method, certain ratios, like liquid assets to short term total liabilities, purchased funds to total assets, core deposits to total assets, loan to deposit ratio, etc., are calculated and compared to the benchmarks that a bank has set for itself. While the stock approach helps up in looking at liquidity from one angle, it does not reveal the intrinsic liquidity profile of a bank. The flow approach, on the other hand, forecasts liquidity at different points of time. It looks at the liquidity requirements of today, tomorrow, the day thereafter, in the next seven to 14 days and so on. The maturity ladder, thus, constructed helps in tracking the cash flow mismatches over a series of specified time periods. The liquidity controls, apart from being fixed maturity-bucket wise, should also encompass maximum cumulative mismatches across the various time bands.
STRESS TESTING
Stress testing should form an integral part of the overall governance and liquidity risk management culture in banks. A bank should conduct stress tests on a regular basis for a variety of short term and protracted bank specific and market wide stress scenarios (individually and in combination). In designing liquidity stress scenarios, the nature of the bank’s business, activities and vulnerabilities should be taken into consideration so that the scenarios incorporate the major funding and market liquidity risks to which the bank is exposed. These include risks associated with its business activities, products (including complex financial instruments and off-balance sheet items) and funding sources. The defined scenarios should allow the bank to evaluate the potential adverse impact these factors can have on its liquidity position. While historical events may serve as a guide, a bank’s judgment also plays an important role in the design of stress tests.
Stress tests outcomes should be used to identify and quantify sources of potential liquidity strain and to analyse possible impacts on the bank’s cash flows, liquidity position, profitability and solvency. The results of stress tests should be discussed thoroughly by ALCO. Remedial or mitigating actions should be identified and taken to limit the bank’s exposures, to build up a liquidity cushion and to adjust the liquidity profile to fit the risk tolerance. The results should also play a key role in shaping the bank’s contingent funding planning and in determining the strategy and tactics to deal with events of liquidity stress.
The stress test results and the action taken should be documented by banks and made available to the Reserve Bank/Inspecting Officers as and when required. If the stress test results indicate any vulnerability, these should be reported to the Board and a plan of action charted out immediately. The Department of Banking Supervision, Central Office, Reserve Bank of India should also be kept informed immediately in such cases.
CONTINGENCY FUNDING PLAN
A bank should formulate a contingency funding plan (CFP) for responding to severe disruptions which might affect the bank’s ability to fund some or all of its activities in a timely manner and at a reasonable cost. CFPS should prepare the bank to manage a range of scenarios of severe liquidity stress that include both bank specific and market-wide stress and should be commensurate with a bank’s complexity, risk profile, scope of operations. Contingency plans should contain details of available/potential contingency funding sources and the amount/estimated amount which can be drawn from these sources, clear escalation prioritisation procedures detailing when and how each of the actions can and should be activated and the lead time needed to tap additional funds from each of the contingency sources.
Contingency plans must be tested regularly to ensure their effectiveness and operational feasibility and should be reviewed by the Board at least on an annual basis.