Liquidity Risk in Banking

Liquidity planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets, promptly and at a reasonable cost. It encompass the potential sale of liquid assets and borrowings from money, capital and Forex markets. Thus, liquidity should be considered as a defense mechanism from losses on fire sale of assets.

Liquidity risk in banking is the potential inability of a bank to meet its payment obligations in a timely and cost effective manner. It arises when the bank is unable to generate cash to cope with a decline in deposits/liabilities or increase in assets.

The cash flows are placed in different time buckets based on future behavior of assets, liabilities and 0ff-balance sheet items.

Liquidity may be defined as the ability to meet commitments and/or undertake new transactions. The most obvious form of liquidity risk is the inability to honor desired withdrawals and commitments, that is, the risk of cash shortages when it is needed which arises due to maturity mismatch.

Banking can also be described as a business of maturity transformation. Usually banks, lend for a longer period than for which they borrow. Therefore, they generally have a mismatched balance sheet in so far as their short-term liabilities are greater than short-term assets and long-term assets are greater than long term liabilities.

Liquidity risk in banking is measured by preparing a maturity profile of assets and liabilities, which enables the management to form a judgement on liquidity mismatch. As the basic problem for a bank is to ascertain whether it will be able to meet maturing obligations on the date they fall due, it must prepare a projected cash-flow statement and estimate the probability of facing any liquidity crisis.

Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The important methods of measuring liquidity risk in banking are:

  • To manage liquidity risk, banks should keep the maturity profile of liabilities compatible with those of assets.
  • The behavioral maturity profile of various components of on/off balance sheet items is being analysed and variance analysis is been undertaken regularly.
  • Efforts are also being made by some banks to track the impact of repayment of loans and premature closure of deposits to estimate realistically the cash flow profile.
  • Banks are closely monitoring the mismatches in the category of 1-14 days and 15-28 days time bands and tolerance levels on mismatches are being fixed for various maturities, depending on asset-liability profile, stand deposit base nature of cash flows, etc.

Liquidity Risk in banking means, the bank is not in a position to make its repayments, withdrawal, and other commitments in time.

Liquidity risk consists of Funding Risk, Time Risk, and Call Risk.

The liquidity risk in banks manifest in different dimensions:

  • Funding Risk – It is the need to replace net outflows due to unanticipated withdrawals/non-renewal of deposits (wholesale and retail)
  • 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
  • Call Risk – It happens due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their maturity: (a) profiles, (b) cost, (c) yield, (d) risk exposures, etc. It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities.

Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc. Bank should track the impact of pre-payment of loans and premature closure of deposits so as to realistically estimate the cash flow profile.

The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting/reviewing, etc.

While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, 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 at selected maturity dates is recommended as a standard tool.

The format prescribed by RBI in this regard under Asset Liability Management System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on future behavior of assets, liabilities and off-balance sheet items.

In other words, banks should have to analyze the behavioral maturity profile of various components of on / off- balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be fine-tuned over a period which facilitates near reality predictions about future behavior of on/off-balance sheet items.

Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallized.

The difference between cash inflows and outflows in each time period, the excess or deficit of funds becomes a staring point for a measure of a bank’s future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis:

  1. Cap on inter-bank borrowings, especially call borrowings;
  2. Purchased funds vis-à-vis liquid assets;
  3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity reserve Ratio and Loans;
  4. Duration of liabilities and investment portfolio;
  5. Maximum cumulative outflows. Banks should fix cumulative mismatches across all time bands;
  6. Commitment Ratio – track the total commitments given to corporate/banks and other financial institutions to limit the off-balance sheet exposures;
  7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out of contingent liabilities in normal situation and the scope for a n increase in cash flows during periods of stress should also e estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc.

Alternative Scenarios

The liquidity profile of banks depends on the market conditions, which influence the cash flow behavior. Thus, banks should evaluate liquidity profile under different conditions, viz. normal situation, bank specific crisis and market crisis scenario. The banks should establish benchmark for normal situation; cash flow profile of on / off balance sheet items and manages net funding requirements.

Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It should be assumed that the purchased funds could not be easily rolled over; some of the core deposits could be prematurely closed; a substantial share of assets have turned into non-performing and thus become totally illiquid. These developments would lead to rating down grades and high cost of liquidity. The banks should evolve contingency plans to overcome such situations.

The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank of India, general perception about risk profile of the banking system, severe market disruptions, failure of one or more of major players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of high value customer deposits and purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. The banks could also sell their investment with huge discounts, entailing severe capital loss.

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