FIN 6002 – Session 26

Pradeepta Sethi
TAPMI
 Liquidity risk
• Liquidity risk - The bank might not be able to generate
sufficient cash flow to meet its financial obligations.
• Liquidity risk arises for two reasons: a liability-side
reason and an asset-side reason.
• The liability-side reason occurs when bank’s
depositors seek to cash in their financial claims
immediately. When liability holders demand cash by
withdrawing deposits all at once, the bank needs to
borrow additional funds or sell assets to meet the
withdrawal as the cash reserve will be insufficient.
• The asset-side reason occurs when customers
request loan / exercise their credit line. The bank has
to fund the loan on the balance sheet immediately; this
creates a demand for liquidity.
• Similarly, any change in the value of the investment
portfolio of a bank due to interest rate changes
impacts liquidity.
• A bank can meet such a liquidity need by running
down its cash assets, selling off other liquid assets, or
borrowing additional funds.
 Liquidity Risk

Funding Need to replace net outflows due to unanticipated

withdrawals (pre-mature closure of deposits/non-renewal
risk of deposits).

Need to compensate for non-receipt of expected inflows

Time risk of funds (Deterioration in the asset quality).

Crystallisation of contingent liabilities and unable to

undertake profitable business opportunities when
Call Risk available. (conversion of non-fund based limit to fund-
based limit)
 Liquidity risk ➟ Bank runs
• Under normal conditions and with appropriate
management planning, neither net deposit withdrawals
nor the exercise of loan commitments poses
significant liquidity problems.

• Major liquidity problems can arise, if deposit drains are

abnormally large and unexpected.

• When depositors realize that a bank’s assets are

valued at less than its deposits – depositors lose faith
– depositors who do not really need to withdraw
deposits for consumption needs, rationally seek to
withdraw their funds immediately when they observe a
sudden increase in the lines at their bank.

• As a bank run develops, the demand for net deposit

withdrawals grows.

• The bank may initially meet this by decreasing its cash

reserves, selling off liquid or readily marketable assets
such as T-bills, and borrowing in the money markets.
 Liquidity risk ➟ Bank runs

• With increase in the intensity of bank run, more

depositors join the withdrawal line, and a liquidity crisis
develops.
• Now the banks finds it difficult to borrow in the money
markets at virtually any price as it has already sold all
its liquid assets, cash, and bonds as well as any
salable loans.
• The bank is likely to have left only relatively illiquid
loans to meet depositor claims for cash.
• A bank needing to liquidate long-term assets at fire-
sale prices to meet continuing deposit drains faces the
strong possibility that the proceeds from such asset
sales are insufficient to meet depositors’ cash
demands.
• The bank’s liquidity problem then turns into a solvency
problem.
 Liquidity Risk Management

• Assets commonly considered to be liquid, such as

Government securities and other money market instruments,
could also become illiquid when the market and players are
unidirectional.

• Therefore, liquidity has to be tracked through maturity or cash

flow mismatches.

• For measuring and managing net funding requirements, the

use of a maturity ladder and calculation of cumulative surplus
or deficit of funds at selected maturity dates is adopted as a
standard tool.
Factors affecting liquidity risk

• Over extension of credit

• High level of NPAs / Poor asset quality
• Mismanagement
• Reliance on a few wholesale depositors
• Large undrawn loan commitments
• Lack of appropriate liquidity policy & contingent
plan etc
 Outflows

• Capital, Reserves & Surplus

• Deposits
• Borrowings and bonds
• Other liabilities
Maturity
Profile Inflows

• Cash
• Balance with RBI
• Balance with other banks
• Investments
• Advances
In order to capture the maturity structure of the cash inflows and
outflows, the Statement of Structural Liquidity is prepared and
reported fortnightly.

Maturity profile used for measuring the future cash flows of banks
in different time buckets.
1 to 14 Over 3 Over 6 Over 3
29 days & Over 1
days 15 to 28 months & months & years & Over 5
up to 3 year & up
(Next, 2- days up to 6 up to 12 up to 5 years
months to 3 years
7d, 8.14d) months months years

Statement of Structural Liquidity

 Statement of structural
liquidity
• Places all cash inflows and outflows in
the maturity ladder as per residual
maturity
• Maturing liabilities: cash outflow
• Maturing assets : cash Inflow
• Classified in to 8-time buckets
• Mismatches in the first two buckets not to
exceed 20% of outflows
• Shows the structure as of a particular
date
• Banks can fix higher tolerance level for
other maturity buckets.
 1-14d 15-28d 30d-3m 3m – 6m 6m – 1Y 1Y – 3Y 3Y - 5Y Over 5 Y Total

Capital 200 200

Liab -fixed Int 300 200 200 600 600 300 200 200 2600
Liab - floating Int 350 400 350 450 500 450 450 450 3400
Others 50 50 0 200 300
Total outflow 700 650 550 1050 1100 750 650 1050 6500
Investments 200 150 250 250 300 100 350 900 2500
Loans - fixed Int 50 50 0 100 150 50 100 100 600
Loans - floating int 200 150 200 150 150 150 50 50 1100
Loans BPLR Linked 100 150 200 500 350 500 100 100 2000
Others 50 50 0 0 0 0 0 200 300
Total Inflow 600 550 650 1000 950 800 600 1350 6500
Gap -100 -100 100 -50 -150 50 -50 300 0
Cumulative Gap -100 -200 -100 -150 -300 -250 -300 0 0
Gap % to Total
Outflow -14.29 -15.38 18.18 -4.76 -13.64 6.67 -7.69 28.57

Statement of Structural Liquidity

 Liquidity Risk Management
¢ The mismatches (negative gap) during the time buckets of 1-14 days and 15-28
days in the normal course should not to exceed 20% of the cash outflows in the
respective time buckets.
¢ The net cumulative negative mismatches during the Next day, 2-7 days, 8-14
days and 15-28 days buckets should not exceed 5% ,10%, 15% and 20% of the
cumulative cash outflows in the respective time buckets in order to recognize
the cumulative impact on liquidity.
¢ The gap can be financed from market borrowings (call / term), Bills
Rediscounting, Repos and deployment of foreign currency resources after
conversion into rupees (unswapped foreign currency funds ), etc.
¢ If higher tolerance level is needed by bank in view of its asset - liability profile,
then the higher tolerance limit has to be sanctioned by its Board/Management
Committee giving reasons on the need for such higher limit.
¢ Banks with large branch network can (on the stability of their deposit base as
most deposits are renewed) afford to have larger tolerance levels in
mismatches if their term deposit base is quite high.
 • Gap can be positive or negative.

• Positive Gap: Maturing assets >

Maturing liabilities

• In case of positive gap - excess liquidity

can be deployed in money market
Addressing instruments, creating new assets &
investment etc.
the Gap
• Negative Gap: Maturing liabilities >
Maturing assets

• Negative gap can be financed from

market borrowings (call/term), Bills
rediscounting, Repos & deployment of
foreign currency converted into rupee.
Currency Risk

• Large cross border flows together with the

volatility has rendered the banks' balance sheets vulnerable to
exchange rate movements.
• Mismatched currency position besides exposing the balance sheet to
movements in exchange rate also exposes it to country risk and
settlement risk.
• End of the day near square position - banks have been setting up
overnight limits and selectively undertaking active day time trading.
• Banks have been given the discretion to set up overnight limits linked to
maintenance of additional Tier I capital to the extent of 5% of open
position limit.