Discussed below are these two models of technical approach used for liquidity risk management in banks.
1. Working Funds Approach:
Under this approach, liquidity position is assessed based on the quantum of working funds available to the bank. Since working funds reflect the total resources available with the bank to execute its business operations, the amount of liquidity is given as a percentage to the total working funds. The bank can arrive at this percentage based on its historical performance. This approach of forecasting liquidity requirement takes a broad overview of the liquidity position since the working funds are taken as a consolidated figure.
The working funds comprise of owned funds, deposits and float funds. Instead of a consolidated approach, the bank can have a segment-wise break up of the working funds to arrive at the percentage for maintaining liquidity. Based on the position of the limit arrived as above and the available liquidity, the bank will have to invest borrow the surplus/deficit balances to adjust the liquidity position. In this approach, the bank will have to assess the liquidity requirements for each of the components of working funds.
The liquidity for the owned funds component, due to its very nature of being owners’ capital will be nil. The second component of working funds is deposits, the liquidity requirements of which depend on the maturity profile. Thus, prior to assessing the liquidity requirements of these deposits, the bank should categorize them into different segments based on the withdrawal pattern. All deposits based on their maturity fall under the following three categories:
- Volatile Funds
- Vulnerable Funds
- Stable Funds
Volatile funds include those deposits, which are sure to be withdrawn during the period for which the liquidity estimate is to be made. These include, short-term deposits like the 30 days deposits, etc. raised from the corporate high net worth clients of the bank. The probability of these funds being withdrawn before or on their maturity is high. Included in this category of volatile funds are current deposits of corporates that also have a high degree of variability. Due to the nature of the volatile funds, they demand almost 100 percent liquidity maintenance since the demand for funds can arise at any time.
Deposits, which are likely to be withdrawn during the planning tenure, are categorized as vulnerable deposits. A very good example of this type of deposits is the savings deposits. However, the entire quantum of savings deposits cannot be considered as vulnerable. On an average, it can be observed from the operations of the bank, that there will be a certain level up to which the funds are stable i.e. the level below which the funds will not be withdrawn. Hence, the liquidity requirements to meet the maturity of the vulnerable funds will be less than 100 percent and varies depending upon the risk-return policy of the bank.
Finally, the residual of the deposit base after segregating them into the above two categories will fall under the stable funds category. These deposits have the least probability of being withdrawn during the planning period and hence the liquidity to be maintained to meet the maturing stable deposits will also be lower when compared to the other two types of deposits. As explained above, the stable portion of the savings deposits fall under this category. Most of the term deposits, by their nature fall under this category.
Float funds, which are the third component of the working funds, are much similar to the volatile funds. These funds are generally in transit and comprise of DD’s, Banker’s cheques, etc. which may be presented for payment at any time. However, this segment also has a minimum level over and above which the variability occurs. Hence, 100 percent liquidity will have to be provided for the variable component.
Based on the working funds, consolidated or component-wise, the bank will have to assess the cash balances/ liquidity position in the following manner:
- Lay down the average cash and bank balances to be maintained as a percentage of total working funds.
- Lay down the range of variance that can be taken as the acceptance level.
Having obtained the consolidated/component-wise working funds, the bank will now have to estimate the average cash and bank balances that are to be maintained. This average balance can be maintained as a percentage to the total working funds. This percentage level is based on forecasts, the accuracy levels of which vary depending on the factors affecting the cash flows. Hence, it is advisable for the bank to set up a variance range for acceptance depending on its profitability requirements. Thus, as long as the average balances vary within this tolerance range, profitability and liquidity are ensured. Any balance beyond this range will necessitate corrective action either by deploying the surplus funds or by borrowing funds to meet the deficit. This acceptance level is, however, a dynamic figure since it depends on the working funds that may keep changing from time to time.
2. Cash Flows Approach:
This method of forecasting liquidity tries to eliminate the drawback faced in the Working Funds approach by forecasting the potential increase/decrease in deposits/credits accommodation. To tackle such a situation, trend can be established based on historical data about the change in the deposits and loans.
Before proceeding to discuss about the cash flows approach it is essential to understand two important parameters that relate to the approach. Firstly, it is the decision regarding the planning horizon for the forecasts and secondly, the costs involved in forecasting.
The planning horizon of a bank may be a financial year or a part of it i.e. a few months to a quarter/half-year period. The bank should ensure that the planning horizon for estimating the liquidity position should neither be too long or too short if the benefits of forecasting are to be reaped. There are various factors both external and internal to the bank which have an impact on the forecasted cash flows. Thus, when the forecasts are made for a long period they might actually not remain the same thereby affecting all the decisions that have been taken based on such forecasts. Similarly when the planning horizon is too short, decisions relating to borrowings and investments may not be effective enough to increase profitability. Considering these factors, the bank should decide on a period which will not affect the forecasted cash flows to a large extent and at the same time will enable it to make optimal investment-borrowing decisions.
Forecasting cash flows to assess and manage the liquidity position of the bank, however, involves expenditure. These forecasting costs can further be classified into recurring costs and non-recurring costs. Non-recurring costs are those, which occur when the bank initiates the cash forecasting process. These include cash outflows for installation of the necessary information system that collates and maintains the data necessary for forecasting. On the other hand, there are certain recurring costs occurring on a regular basis, which include the man-hours spent, data transmission costs and the maintenance of the systems used for this process.
These costs incurred in forecasting further depend on three important factors viz. branch networking, forecasting periods within the planning horizon and the details of information required for forecasting. By nature, these three factors have a direct influence on the forecasting costs. This can be explained by the fact that if the bank has a wide branch network, it will definitely have to incur more expenditure since data has to be collated from such a wide network accurately and at regular intervals. Similarly, when the bank plans to forecast its cash position for every month during the planning horizon of, say a year, the cost of forecasting will be more as compared to the expenditure incurred for forecasting will be more as compared to the expenditure incurred for forecasting for every quarter/half-yearly period. Higher costs are involved when detailed information is sought, which needs no explanation.
The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. The basic steps involved in this process are as follows:
- Estimate anticipated changes in deposits
- Estimate the cash inflows by way of loan recovery
- Estimate the cash outflows by way of deposit withdrawals and credit accommodations
- Forecast these for the end of each period
- Estimate the liquidity needs over the planning horizon
The most critical task of liquidity risk management in banks is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursal’s. In this process, accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursal’s are fairly high, when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. Thus the process of forecasting cash flows with a high degree of accuracy holds the key to liquidity risk management in banks.
All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month, when the forecasting period is chosen as a month. In order to manage the intra-month liquidity problems, there should always be a surplus balance. In such a scenario, it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. Thus, funds should be provided to meet the deficit balance at the beginning of the forecasting period.