Liquidity risk is inherent in bank’s core business because banking organizations employ a significant amount of leverage in their business activities and need to meet contractual obligations in order to maintain the confidence of customers and fund providers. The first step in measuring and managing liquidity risk is the identification of the most important sources of risk.
In the Indian context of banking, unexpected liquidity fluctuations are driven mainly by the following items:
- Behavior of non-maturity deposits: A large fraction of deposits, in an Indian bank, consists of low-cost current and savings deposits which do not have any contractual maturity. Moreover, the depositor has the option to introduce or withdraw funds at any point of time. This makes the analysis of future cash inflows and outflows quite difficult. However, it is extremely crucial because the main reason for the closure of banks has been the inability to pay depositors on sudden demand. Therefore, the bank needs to know how much of these deposits is volatile, i.e. likely to flow out at short notice and how much is core or stable, i.e. unlikely to leave the bank. In the absence of contractual maturity, the bank needs to analyze the behavioral maturity of these deposits.
- Renewal patterns of term deposits: If the actual proportion of renewal is more than what the bank expects, it is left with surplus funds which might have to be reinvested at lower rates. If the actual fraction is less than anticipated, the bank faces a liquidity deficit, which might entail higher financing costs. Therefore, the bank needs to carry out a detailed roll-in and roll-out analysis of the term deposits. It should estimate the probability distribution of net deposit changes, preferably on a daily basis. If the distribution is positively skewed, the bank should look for investment opportunities for its surplus funds. If it is negatively skewed, the bank should consider how to finance the net deposit drain.
- Unavailed portion of CC/OD: The bank should estimate how much of its advances portfolio consists of CC/OD, in which the borrower has the right to utilize up to the limit, on demand. This is because some large clients might keep the limit unutilized when the borrowing costs are much lower in the capital markets. They will revert to the bank, for sudden utilization, when borrowing costs are higher in the market. As a result, the bank can neither keep the unutilized funds idle nor deploy them in long-term, illiquid assets. Estimating the volatility and utilization pattern of CC/OD, through behavioural analysis, is extremely important for the bank.
- Off-balance sheet commitments: At the time when off-balance sheet guarantees and commitments are invoked, the bank might suffer a sharp liquidity shock. It should carefully monitor the pattern and impact of exercising these non-funded commitments, in order to minimize unexpected liquidity outflows.
- Embedded options in term loans and deposits: When interest rates rise, depositors might prefer to prematurely withdraw their deposit balances, rather than continuing at the lower contractual rates. This not only increases the financing cost of the bank, but also results in a sharp liquidity outflow. Similarly, sudden prepayment of term loans, in a falling rate environment, might saddle the bank with surplus liquidity. As a result, the bank needs to study the behavioral pattern of premature withdrawal and repayment, to minimize the impact of sudden liquidity shocks.
- Credit Risky assets: The bank might expect the cash inflows from different assets to arrive in full and on time. In such an ideal case, it can plan how to meet its expected cash outflows at different intervals. The problem arises when some of its assets make delayed or partial payments. It might then run into a funding deficit, whereby depositors, CC/OD and other off-balance sheet commitments cannot be paid on demand. To project and guard against the shock, the bank needs to study the historical pattern of cash inflows as per rating categories.
However, the sources of risk mentioned above are very generic. The Liquidity Risk Management policy of a bank should be customized. It should be governed by the size, composition and complexity of its balance sheet.Therefore, the Liquidity Risk Management Policy of a bank should be based on its own risk appetite, skill level, goals and priorities.