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Liquidity Management

Module D: Balance Sheet Management

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

Bank Financial Management: Liquidity Management

CAIIB – SUPER NOTES

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

Contents
Coverage:
1. Introduction

2. Definition
3. Dimensions and Role of
Liquidity Risk Management
4. Measuring and managing
liquidity risk

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

1.

INTRODUCTION

© M S Ahluwalia

CAIIB – Super-Notes

Sirf Business

Very rarely result in solvency risk problems © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Liquidity • Objectives of Asset Liability Management: – Ensuring profitability – Ensuring liquidity • Liquidity – Represented by quality and marketability of assets and liabilities – Exposes the organisation to liquidity risk – Liquidity risk is a normal aspect of everyday management of a financial institution.

DEFINITION © M S Ahluwalia CAIIB – Super-Notes Sirf Business .2.

Liquidity • Required to meet deposit withdrawals and to fund loan demands – To compensate for expected and unexpected balance sheet fluctuations – Provide funds for growth • Represents the ability to accommodate decreases in liability and to fund increases in assets © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

DIMENSIONS AND ROLE OF LIQUIDITY RISK MANAGEMENT © M S Ahluwalia CAIIB – Super-Notes Sirf Business .3.

Liquidity Management • Process of generating funds to meet contractual or relationship obligations a reasonable prices at all times • New loan demands. and deposit withdrawals are the basic contractual or relationship obligations that a bank must meet © M S Ahluwalia CAIIB – Super-Notes Sirf Business . existing commitments.

Functions of Liquidity Management Demonstrates to the market place that bank is safe and has repayment capacity Enables to meet its prior loan commitments – formal or informal Enables bank to avoid unprofitable sale of assets Lowers the size of the default risk premium © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Adequacy determined by analysing Historical Funding requirements Current Liquidity Position Anticipated future funding needs Sources of funds Options for reducing funding needs Present and anticipated asset quality Present and future earnings capacity © M S Ahluwalia Present and planned capital position CAIIB – Super-Notes Sirf Business .

Factors affecting Bank liquidity Decline in Earnings Increase in NPAs Deposit Concentrations Downgrading by rating agencies Expanded business opportunities Acquisitions New tax initiatives © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

How to meet funding requirements? Dispose of Liquid Assets Increase short term borrowings Decrease holdings of less liquid assets Increase liabilities of a term nature Increase capital funds Securitisation of Assets © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Types of Liquidity Risks • Based on source of origin: Internal Perception of Institution in various markets • Local • Regional • National • International © M S Ahluwalia External Geographic Systemic Instrument Specific CAIIB – Super-Notes Sirf Business .

Types of Risks Funding Risk Need to replace net outflows due to unanticipated withdrawals/non-renewal Time Risk Need to compensate for non-receipt of expected inflows of funds Call Risk Crystallization of contingent liability Arises due to: Arises due to: Arises due to: • Fraud Causing substantial loss •Systemic risk •Loss of Confidence •Liabilities in Foreign Currencies •Severe deterioration in asset quality •Standard assets turning into NPA •Temporary Problem in recovery •Time involved in managing liquidity •Conversion of non-fund based limit to fund based limit •Swaps and Options © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

MEASURING AND MANAGING LIQUIDITY RISK © M S Ahluwalia CAIIB – Super-Notes Sirf Business .4.

Elements of strong liquidity management Good management information system Central Liquidity control Diversification of funding sources © M S Ahluwalia CAIIB – Super-Notes Analysis of net funding requirements under alternative scenarios Contingency Planning Sirf Business .

Steps necessary for managing liquidity risks Developing a structure for managing liquidity risk Setting tolerance level and limit for liquidity risk Measuring and Managing Liquidity Risk © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

monitoring and controlling liquidity risk © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Developing a structure for managing liquidity risk • Liquidity Risk Management Involves – Setting a strategy for the bank ensuring effective board and senior management oversight – Operating under a sound process for measuring.

Strategy should • Set out general approach to liquidity including quantitative and qualitative targets • Address bank’s goal of protecting financial strategy and ability to withstand stressful events • Enunciate specific policies on particular aspects of liquidity management • Be communicated throughout the organisation ----- • Board should monitor performance and liquidity risk profile of bank • Bank should have a liquidity management structure in place © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Treatment of Foreign Currencies Adds complexity to liquidity management as: 1. Banks less well known to liability holders in foreign currency markets who may not be in a position to correctly assess domestic market situations 2. In the event of disturbance bank may not be able to mobilise domestic liquidity to meet foreign currency funding requirements © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Management Structure: i) Complete Centralisation of Liquidity management ii) Decentralise by assigning operating divisions responsibility for their liability subject to limits imposed by HO or frequent/routine reporting to HO iii) Responsibility for liquidity in home currency and overall coordination to home office and responsibility for bank’s global liquidity in major foreign currencies to the management of foreign office in the country issuing the respective currency © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Treatment of Foreign Currencies Management must make two key decisions: 1.

Liquidity strategy in each currency: Bank’s assessment will depend upon: - - Funding needs - Access to foreign currency funding market - Capacity to rely on off balance sheet instruments (SBLC. Swaps etc) Bank must also develop a back-up liquidity strategy © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Treatment of Foreign Currencies 2.

Setting tolerance level and limit for liquidity risk • Limits could be set on the following lines: – Cumulative cash flow mismatches over particular period taking conservative view of marketability of liquid assets – Liquid assets as percentage of short-term liabilities – A limit on Loan to deposit ratio – A limit on loan to capital ratio – Limit on relationship between anticipated funding needs and available sources – Primary sources for meeting funding needs should be quantified – Flexible limits on %age reliance on a particular liability category – Dependence on individual customers and market segments – Flexible limits on min/max average maturity of different categories of liabilities – Minimum liquidity provision to be maintained to sustain operations © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Stock Approach 2.Measuring and Managing Liquidity Risk Approaches: 1. Flow Approach © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Ratio of Time Deposits to Total Deposits: •Time Deposits/Total Deposits •Higher the Ratio better Ratio of Volatile liabilities to total assets •Volatile Liabilities/Total Assets •Lower the Ratio the Better © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Stock Approach • Based on the level of assets and liabilities as well as Off-Balance sheet exposures on a particular date Ratio of Core Deposit to total Assets: •Core Deposit/Total Asset •More the ratio better it is because core deposits are stable sources of liquidity. Lower the ratio is the better. Net Loans to Total deposits Ratio: •Net Loans/Total Deposit •It reflects the ratio of loans to Public Deposits or core deposits.

Stock Approach Ratio of Short Term Liabilities to Liquid Assets: • Short Term Liabilities/Liquid Assets: • Lower the Ratio the better Ratio of Liquid Assets to Total Assets: • Higher the Ratio the better Ratio of Short Term Liabilities/Total Assets: • A lower ratio is desirable Ratio of Prime Asset to Total Asset: • Higher the ratio the better Ratio of Marketable liability to total asset: • Lower the ratio better Indian Banks do not follow this approach © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Managing market access 3.Flow Approach • Also known as Gap Method • Three major dimensions: 1. Contingency Planning • Requires preparation of structural liquidity gap report • Calculated on the basis of residual maturities of assets and liabilities © M S Ahluwalia CAIIB – Super-Notes Sirf Business . Measuring and Managing net funding requirements 2.

liabilities and off balance sheet items.Measuring and Managing net funding requirements • Analysis of net funding requirements involves construction of a maturity ladder and calculation of a cumulative net excess or deficit of funds at selected maturity dates • Bank’s net funding requirements are determined by analysing its future cash flows based on assumptions of the future behaviour of assets. and then calculating the net excess over the time frame of liquidity assessment © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Aspects Maturity Ladder Alternative Scenarios Measuring liquidity over the chosen time frame Assumptions used in determining cash flows © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

especially committed lines of credit that can be drawn down © M S Ahluwalia CAIIB – Super-Notes Sirf Business .The Maturity Ladder • To compare a bank’s future cash inflows to its future cash outflows over a series of specified time periods • Inflows arise from – Maturing assets – Saleable non-maturing assets – Established credit lines that can be trapped • Outflows include – Liabilities falling due – Contingent liabilities.

earliest date a liability holder could exercise an early repayment option or the earliest dates contingencies can be called – Significant interest and other cash flows should also be included • The gap for a specific period may thereafter be measured © M S Ahluwalia CAIIB – Super-Notes Sirf Business .The Maturity Ladder • Bank has to allocate each cash flow to a given date – Cash inflows can be ranked by the date on which assets mature or a conservative estimate of when credit lines can be drawn down – Cash outflows can be ranked by the date on which liabilities fall due.

especially in crisis scenarios © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Alternative Scenarios General Market Conditions • Benchmark for the ‘normal business’ behavior of the balance sheet • Useful in managing a bank’s use of deposits and other debt markets Bank Specific Crisis • A type of ‘worstcase’ benchmark • Many of the bank’s liabilities could not be rolled over or replaced and would have to be repaid at maturity so that the bank would have to wind down its books to some degree General Market Crisis • Liquidity is affecting all banks in one or more markets • Differences in funding access amongst banks or among classes of financial institutions would widen • Second type of ‘worst-case’ benchmark Judgment often plays a large role.

Measuring liquidity over the chosen time frame • A stylised liquidity graph can be constructed. enabling the evolution of the cumulative net excess or deficit of funds to be compared under the three scenarios to provide further insights into a bank’s liquidity and to check how consistent and realistic the assumptions are for the individual bank © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

Least Liquid) • Use of existing assets as collateral • Extent to which maturing assets will be renewed • Acquisition of new assets Assumptions regarding liabilities • Level of rollovers of deposits and other liabilities • Effective maturity of deposits with non-contractual maturities • Growth in new deposit accounts Assumptions regarding Off balance sheet activities • Level of cash outflows on crystallization of contingent liabilities Other Assumptions • Funds to support operations • Net overhead expenses © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Assumptions used in determining cash flows Assumptions regarding assets • Potential Marketability (Most Liquid. Less Liquid.

Managing Market Access • It is important for a bank to review periodically its efforts – to maintain the diversification of liabilities – to establish relationships with other liability holders – to develop asset-sales markets • Examine level of reliance on individual funding sources • Strive to understand and evaluate the use of inter-company financing for individual business offices © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

uninterrupted flow of information • Clear division of responsibility • Strategy for taking certain actions to alter asset and liability behaviours • Relationships • Dealing with Press and Broadcast media – Does management have procedures in place for accessing cash in emergency? • Back up liquidity for emergency situations © M S Ahluwalia CAIIB – Super-Notes Sirf Business .Contingency Planning • Should address two major questions: – Does management have a strategy for handling a crisis? • Procedures to ensure timely.

RBI Guidelines for maturity buckets • All Assets & Liabilities to be reported as per their maturity profile into 10 maturity Buckets: – Tomorrow – 2 to 7 days – 8 to 14 days – 15 to 28 days – 29 days and up to 3 months – Over 3 months and up to 6 months – Over 6 months and up to 1 year – Over 1 year and up to 3 years – Over 3 years and up to 5 years – Over 5 years © M S Ahluwalia CAIIB – Super-Notes Sirf Business .

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is a visual artist. To know more about him you may visit his blog-site: Estudiante De La Vida © M S Ahluwalia For more Super-Notes: Click Here CAIIB – Super-Notes Sirf Business . blogger.M S Ahluwalia. India. blog designer and of course an MBA and Banker from New Delhi. amongst other things.