Liquidity Risk Management in Banks

While introducing the concept of Asset-Liability Management (ALM), it has been mentioned that the object of any ALM policy is twofold — ensuring profitability and liquidity. Working towards this end, the bank generally maintains profitability/spreads by borrowing short (lower costs) and lending long (higher yields). Though this process of price matching can be done well within the risk/exposure levels set for rate fluctuations it may, however, place the bank in a potentially illiquid position.

Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. Price matching should be coupled with proper maturity matching. The inter-linkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. The underlying implication of this inter-linkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank.

Thus, while management of the prices of assets and liabilities is an essential part of Asset-Liability Management, so is liquidity. Liquidity, which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk. Though the management of liquidity risks and interest rate risks go hand in hand, there is, however, a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination risk does result in long-term sustenance. Before attempting to analyze the elimination of liquidity risk, it is essential to understand the concept of liquidity management.

The core activity of any bank is to attain profitability through fund management i.e. acquisition and deployment of financial resources. An intricate part of fund management is liquidity management. Liquidity management relates primarily to the dependability of cash flows, both inflows and outflows and the ability of the bank to meet maturing liabilities and customer demands for cash within the basic pricing policy framework. Liquidity risk hence, originates from the potential inability of the bank to generate cash to cope with the decline in liabilities or increase in assets.

Thus, the cause and effect of liquidity risk are primarily linked to the nature of the assets and liabilities of the bank. All investment and financing decisions of the bank, irrespective of whether they have long term or short term implications do effect the asset-liability position of the bank which may further affect its liquidity position. In such a scenario, the bank should continuously monitor its liquidity position in the long run and also on a day-to-day basis.

Approaches to Liquidity Risk Management in Banks

Given below are two approaches to liquidity risk management in banks, that relate to these two situational decisions:

  1. Fundamental Approach.
  2. Technical Approach.

These two methods distinguish from each other in their strategically approach to eliminate liquidity risk. While the fundamental approach aims to ensure the liquidity for long run sustenance of the bank, the technical approach targets the liquidity in the short run. Due to these features, the two approaches supplement each other in eliminating the liquidity risk and ensuring profitability.

1. Fundamental Approach

Since long run sustenance is driving factor in this approach, the bank tries to tackle /eliminate the liquidity risk in the long run by basically controlling its assets-liability position. A prudent way of tackling this situation can be by adjusting the maturity of assets and liabilities or by diversifying and broadening the sources of funds.

The two alternatives available to control the liquidity exposure under this approach are Asset Management and Liability Management. This implies that liquidity can be imparted into the system either by liability creation or by asset liquidation, which eve suite the situation.

  1. Asset Management: Asset management is to eliminate liquidity risk by holding near cash assets i.e. those assets, which can be turned into cash whenever required. For instance, sale of securities from the investment portfolio can enhance liquidity. When asset management is resorted to, the liquidity requirements are generally met from primary and secondary reserves. Primary reserves refer to cash assets held to meet the statutory cash reserve requirements (CRR) and other operating purposes. Though primary reserves do not serve the purpose of liquidity management for long period, they can be held as second line of defense against daily demand for cash. This is possible mainly due to the flexibility in the cash reserve balances (statutory cash reserves are required to be maintained only on a daily average basis for a reserve maintenance period). However, most of the liquidity is generally attained from the secondary reserves, which include those assets held primarily for liquidity purposes. These secondary reserves are highly liquid assets, which when converted into cash carry little risk of loss in their value. Further, they can also be converted into cash prior to their maturity at the discretion of the management. When asset management is resorted to for liquidity, it will be through liquidation of secondary reserves. Assets that fall under this category generally take the form of unsecured marketable securities. The bank can dispose these secondary reserves to honor demands for deposit withdrawals, adverse clearing balances or any other reasons.
  2. Liability Management: Converse to the asset management strategy is liability management, which focuses on the sources of funds. Here the bank is not maintaining any surplus funds, but tries to achieve the required liquidity by borrowing funds when the need arises. The underlying implications of this process will be that the bank mostly will be investing in long-term securities /loans (since the short-term surplus balance will mostly be in a deficit position) and further, it will not depend on its liquidity position/surplus balance for credit accommodation/business proposals. Thus in liability management a proposal may be passed even when there is no surplus balance since the bank intends to raise the required funds from external sources. Though it involves a greater risk for the bank, it will also fetch higher yields due to the long-term investments. However, sustenance of such high spreads will depend on the cost of borrowing. Thus, the cost and the maturity of the instrument used for borrowing funds play a vital role in liability management. The bank should on the one hand be able to raise funds at low cost and on the other hand ensure that the maturity profile of the instrument does not lead to or enhance the liquidity risk and the interest rate risk. Of the two strategies available in fundamental approach, it is understood that while asset management tries to answer the basic question of how to deploy the surplus to eliminate liquidity risk, liability management tries to achieve the same by mobilizing additional funds.

2. Technical Approach

As mentioned earlier, technical approach focuses on the liquidity position of the bank in the short run. Liquidity in the short run is primarily linked to the cash flows arising due to the operational transactions. Thus, when technical approach is adopted to eliminate liquidity risk, it is the cash flows position that needs to be tackled. The bank should know its cash requirements and the cash inflows and adjust these two to ensure a safe level for its liquidity position.

Working Funds Approach and the Cash Flows Approach are the two methods to assess the liquidity position in the short run. Of these two approaches, the former concentrates on the actual cash position and depending on the factual data, it forecasts the liquidity requirements. The latter approach goes a step forward and forecasts the cash flows i.e. estimates any change in the deposits withdrawals credit accommodation etc. Thus apart from assessing the liquidity requirements, it also advises the bank on its investments and borrowing requirements well in advance.

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