AN ASSIGNMENT ON

“LIQUIDITY RISK ISSUES FACED BY BANKING SECTOR”

SUBMITTED TO

AMITY UNIVERSITY KOLKATA

for the partial fulfilment of the award of the degree

MASTER OF BUSINESS ADMINISTRATON

BY

DEEPA GOENKA

ENROLLMENT NO: A91801922041

BATCH:2022-2024, SEMESTER -4th, SECTION: A

COURSE: RISK MAMAGEMENT (FIBA731)

FACULTY GUIDE: MS. MADHUMITA DAS GUPTA

AMITY BUSINESS SCHOOL

AMITY UNIVERSITY, KOLKATA

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CONTENT

SL
INDEX PAGE NO.
NO.

1 INTRODUCTION TO LIQUIDITY RISK 3

2 TYPES OF LIQUIDITY RISK 4-5

3 INTRODUCTION TO THE BANKING SECTOR 6-7

IMPLICATION OF LIQUIDITY RISK IN

4 8-9
BANKING SECTOR

5 LIQUIDITY RISK MANAGEMENT 10-11

MAJAOR CHALLENGES OF
6 12-13
LIQUIDITY RISK MANAGEMENT IN BANKS

7 CONCLUSION 14

8 BIBLIOGRAPHY 15

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INTRODUCTION TO LIQUIDITY RISK

Liquidity is the ease with which any asset can be sold and converted to cash. Thus ‘liquidity
risk’ is the risk of not being able to make this conversion easily. Liquidity risk can put a
company in a precarious position. If it is unable to sell its assets or investments fast enough to
raise cash for debt repayments, it is said to be facing liquidity risk and can get in trouble for
failing its obligation.

Liquidity risk is inversely proportional to the size of the asset issue or its issuer. For example,
if a lesser-known company goes public, it may not attract enough investors and in turn fail to
garner the funds it seeks to raise. Hence, investors and shareholders use liquidity ratios to
measure how capable a company is to repay its short-term debt. Highly leveraged companies
commonly undergo this scrutiny for the same purpose.

Liquidity risk is a critical concern for banks and financial institutions, encompassing the risk
of being unable to meet short-term financial obligations due to an inability to liquidate assets
or obtain funding at reasonable costs. It arises from a variety of factors inherent in banking
activities and the broader financial system. Understanding liquidity risk is essential for
maintaining the stability and solvency of banks, as well as for safeguarding the overall health
of the financial system.

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TYPES OF LIQUIDITY RISK

Liquidity risk can manifest in various forms within the banking sector, each with its own
characteristics and implications. Here are the types of liquidity risk in detail:

1. Funding Liquidity Risk:

This type of liquidity risk arises when a bank is unable to meet its funding obligations as they
come due. It occurs due to a mismatch between the timing of cash outflows (liabilities
maturing) and inflows (funding sources available). Factors contributing to funding liquidity
risk include:

• Heavy reliance on short-term funding sources such as interbank borrowing or

wholesale funding markets.
• Inability to roll over maturing liabilities or replace them with new funding at
reasonable costs.
• Sudden withdrawal of deposits by customers, particularly in response to
deteriorating market conditions or loss of confidence.
• Tightening of credit conditions or reduced access to funding in the interbank
market.

Managing funding liquidity risk involves maintaining sufficient liquid assets, diversifying
funding sources, and establishing contingency funding plans to address potential funding
shortfalls.

2. Market Liquidity Risk:

Market liquidity risk refers to the risk of being unable to sell assets quickly in the market
without significantly affecting their prices. This risk arises due to the illiquidity of assets held
by the bank, which may result in losses or funding difficulties if the bank needs to sell assets
to raise funds urgently. Factors contributing to market liquidity risk include:

• Holding assets that are traded infrequently or have limited depth in the market.
• Disruptions in financial markets, such as sudden declines in trading volumes or
increased volatility.

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 • Deterioration in market conditions or investor sentiment, leading to widening
bid-ask spreads and reduced liquidity.

Banks manage market liquidity risk by diversifying their asset portfolios, monitoring market
conditions closely, and conducting stress testing to assess the impact of adverse market
scenarios on asset liquidity.

3. Asset-Liability Mismatch Risk:

Asset-liability mismatch risk arises when the maturities of a bank's assets do not align with the
maturities of its liabilities. This imbalance can leave the bank vulnerable to liquidity shortages
if short-term liabilities need to be rolled over or refinanced but long-term assets cannot be
easily liquidated or converted into cash. Factors contributing to asset-liability mismatch risk
include:

• Funding long-term assets with short-term liabilities, exposing the bank to

refinancing risks.
• Concentration of assets with long-term maturities or illiquid characteristics.
• Inadequate planning and management of the asset-liability maturity profile.

Managing asset-liability mismatch risk involves carefully matching the maturities and cash
flow characteristics of assets and liabilities, reducing reliance on short-term funding for long-
term assets, and implementing effective liquidity risk management practices.

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INTRODUCTION TO THE BANKING SECTOR

Banks play an important part in driving a country’s economic progress and running the
financial sector. The banking system is important in promoting economic growth by
channelling funds into investments and increasing resource allocative efficiency. An efficient
Indian Banking System is increasingly seen as a necessary prerequisite for the country’s
development. These institutions, which serve as a hub for savers and investors, are at the heart
of India’s financial system. The Indian banking system is governed by a central bank known
as the Reserve Bank of India (RBI), which controls the entire Indian financial sector.

The Indian Banking System includes commercial banks, regional rural banks, urban
cooperative banks, and primary agricultural credit societies. India’s modern banking began in
the 18th century. The State Bank of India is the biggest and oldest surviving bank. It began as
the Bank of Calcutta in mid-June 1806. Today it is one of the largest lenders in the country.
The Indian subcontinent reaped the benefits of a favourable trade balance, with exports
outnumbering imports by wide percentages.

In India, three kinds of banks form the structure of the Indian banking system:

(i) Scheduled Banks

These are the banks included in the second schedule of the Reserve Bank of India Act of 1934.
These banks are eligible for debts or loans at the RBI’s bank rate. Commercial and cooperative
banks are subdivisions of scheduled banks.

(ii) Non-scheduled Banks

Those banks which are not covered by the second section of the Reserve Bank of India Act,
1934. Except in times of crisis, they cannot borrow from the RBI for traditional banking
purposes.

(iii) Development Financial Institutions or Development Banks

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As per the Reserve Bank of India (RBI), India’s banking sector is sufficiently capitalised and
well-regulated. The financial and economic conditions in the country are far superior to any
other country in the world. Credit, market and liquidity risk studies suggest that Indian banks
are generally resilient and have withstood the global downturn well.

The Indian banking industry has recently witnessed the rollout of innovative banking models
like payments and small finance banks. In recent years India has also focused on increasing its
banking sector reach, through various schemes like the Pradhan Mantri Jan Dhan Yojana and
Post payment banks. Schemes like these coupled with major banking sector reforms like digital
payments, neo-banking, a rise of Indian NBFCs and fintech have significantly enhanced India’s
financial inclusion and helped fuel the credit cycle in the country.

Indian Fintech industry is estimated to be at US$ 150 billion by 2025. India has the 3rd largest
FinTech ecosystem globally. India is one of the fastest-growing Fintech markets in the world.
There are currently more than 2,000 DPIIT-recognized Financial Technology (FinTech)
businesses in India, and this number is rapidly increasing.

The digital payments system in India has evolved the most among 25 countries with India’s
Immediate Payment Service (IMPS) being the only system at level five in the Faster Payments
Innovation Index (FPII).* India’s Unified Payments Interface (UPI) has also revolutionized
real-time payments and strived to increase its global reach in recent years.

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IMPLICATION OF LIQUIDITY RISK IN BANKING SECTOR

Liquidity risk in the Indian banking sector isn't an isolated concern. Its implications can ripple
outwards, impacting various stakeholders and the overall financial health of the economy. Here
are some key implications:

For Banks:

• Reduced Profitability: Fire sales of assets to meet short-term obligations can lead to
significant losses, eroding a bank's profitability.
• Credit Freeze: Banks facing liquidity issues may become reluctant to lend, hindering
economic growth as businesses struggle to access credit.
• Reputational Damage: A bank run or liquidity crisis can severely damage a bank's
reputation, making it difficult to attract new depositors and investors.
• Increased Risk of Bank Failure: In extreme cases, unmanaged liquidity risk can lead
to bank failure, disrupting the financial system and causing panic among depositors.

For Borrowers:

• Loan Defaults: If banks become hesitant to lend due to liquidity concerns, businesses
and individuals may struggle to secure loans, potentially leading to defaults on existing
ones.
• Higher Borrowing Costs: In times of tight liquidity, banks may raise interest rates to
attract deposits and manage their cash flow. This can make borrowing more expensive
for businesses and individuals.
• Stalled Economic Activity: Limited access to credit can hinder business investment
and expansion, impacting economic growth and job creation.

For the Financial System:

• Contagion Effect: A liquidity crisis in one bank can cause panic and loss of
confidence, potentially triggering similar problems in other banks (domino effect).
• Systemic Risk: Widespread bank failures due to liquidity issues can destabilize the
entire financial system, impacting the flow of credit and investment throughout the
economy.

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 • Intervention by the RBI: The Reserve Bank of India might need to intervene by
providing emergency liquidity assistance to banks, which can have an impact on overall
monetary policy.

For the Economy:

• Reduced Investment: Limited access to credit and a shaky financial system can
discourage investment, hindering economic growth and development.
• Job Losses: Stalled economic activity can lead to business closures and job losses,
impacting overall economic well-being.

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LIQUIDITY RISK MANAGEMENT
Management of liquidity risk is critical to ensure that cash needs are continuously met. For
instance, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow
forecasting, and ensuring diversified funding sources are common tactics employed to
mitigate liquidity risk. Additionally, adhering to regulatory frameworks that advocate for
certain liquidity thresholds also serves as a proactive measure in managing liquidity risk.

The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-
reaching. It can lead to financial losses from the sale of assets at depressed prices, operational
disruptions due to inadequate cash flow, and reputational damage which can further
exacerbate liquidity issues. In extreme cases, liquidity risk can drive an entity
towards insolvency or bankruptcy, underscoring the imperative for robust liquidity risk
management practices.

Here’s a deeper dive into how banks navigate the waters of liquidity risk:

1. Maintaining a Balanced Portfolio of Liquid Assets: Banks strive to maintain a

balanced portfolio of liquid assets that can be swiftly converted into cash without
significant loss in value. These assets, often termed as high-quality liquid assets
(HQLA), provide a safety buffer in times of liquidity crunches.
2. Utilizing Liquidity Ratios: Banks employ liquidity ratios like the Liquidity Coverage
Ratio (LCR) and Net Stable Funding Ratio (NSFR) to monitor and manage their
liquidity risk. The LCR ensures that banks have enough high-quality liquid assets to
withstand a 30-day stress scenario, while the NSFR aims to promote longer-term
resilience by requiring a stable funding structure relative to the liquidity profile of the
assets.
3. Stress Testing: Conducting stress tests to simulate adverse market conditions is a key
strategy to identify potential liquidity shortfalls. These tests help banks identify
vulnerabilities and evaluate the adequacy of their liquidity buffers.
4. Diversifying Funding Sources: Diversifying funding sources is a prudent strategy to
mitigate dependency on a single or few sources of funding. This can include a mix of
retail deposits, wholesale funding, and other financing avenues. A diversified funding
structure can provide a more stable and resilient liquidity profile.
5. Effective Cash Flow Management: Banks need to have a robust cash flow
management system to track and manage their cash flows efficiently. This involves
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 monitoring the inflows and outflows, optimizing the asset-liability maturity profile,
and ensuring that there is adequate liquidity to meet both expected and unexpected
cash flow needs.
6. Establishing Contingency Funding Plans (CFP): Banks develop Contingency
Funding Plans to address potential liquidity shortfalls. These plans outline the
strategies and actions to be taken in the event of a liquidity crisis, ensuring a structured
and coordinated approach to managing liquidity under adverse conditions.

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MAJOR CHALLENEGS OF LIQUIDITY RISK MANAGEMENT IN BANKS

The GDP of Q3 of FY24 recorded a growth of 8.4 percent far beyond the street expectation. The
forward outlook of GDP therefore now stands at 7.6 percent for the fiscal FY24, up from 7.3
percent. The results of banks for Q3 of FY24 also reflected continued growth in many critical
business parameters. The capital-to-risk-weighted assets ratio (CRAR) reached a high of 16.8
percent in September 2023. The Gross non-performing assets ratio (GNPA) was down to a
multiyear low at 3.2 percent and net NPAs down to 0.8 percent. Amid such buoyant growth of the
economy and stronger banking system, demand for bank credit will rise putting more pressure on
liquidity that has been running in deficit during most of the current financial year to varying
degrees.

Moreover, while downgrading the rating of ICICI Bank, SBI, and Yes Bank, Goldman Sachs
observed that going forward, the major challenges could be the rising pressure on the cost of funds
due to structural funding constraints. The rising consumer leverage could pose potential asset
quality challenges and higher unsecured lending could lead to higher credit costs. Recently
released minutes of the monetary policy committee reinforced the need for RBI to ensure that the
weighted average call rate (WACR) remains close to the repo rate which tends to move beyond
the MSF rate due to a prolonged systemic liquidity deficit.

While Indian banks have an arsenal of strategies for managing liquidity risk, navigating this
ever-present threat comes with its own set of challenges:

Internal Hurdles:

• Legacy Systems: Outdated technology infrastructure in some banks can hinder real-
time monitoring of cash flow and hinder effective implementation of liquidity risk
management strategies.
• Silos and Lack of Coordination: Disparate data sources and a lack of communication
between different departments within a bank can make it difficult to get a holistic view
of the bank's liquidity position.
• Human Error: Inaccurate data entry or faulty assumptions in liquidity forecasting
models can lead to miscalculations and potentially exacerbate liquidity risks.

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External Pressures:

• Volatile Market Conditions: Sudden economic downturns or disruptions in the

financial markets can make it difficult for banks to access short-term funding or sell
assets quickly without losses.
• Depositor Behavior: Unforeseen surges in deposit withdrawals (bank runs) can create
a liquidity crisis even for well-prepared banks.
• Regulatory Changes: Evolving regulations and reporting requirements can add to the
burden on banks, requiring them to constantly adapt their liquidity risk management
practices.

Unique Challenges for Indian Banks:

• High Dependence on Deposits: Indian banks rely heavily on deposits, a relatively

volatile funding source compared to other instruments.
• Large Public Sector Presence: Public Sector Banks (PSBs) often face challenges with
operational efficiency, which can make them more susceptible to liquidity risks.
• Financial Inclusion Push: Expanding access to banking services to a wider
population, while positive for social development, can also increase the unpredictability
of deposit behavior.

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CONCLUSION

In conclusion, liquidity risk presents significant challenges for banks, encompassing the
potential inability to meet short-term funding obligations without incurring excessive costs or
losses. The issues faced by banks in managing liquidity risk are multifaceted and require careful
attention and proactive management. From dependence on short-term funding sources to
regulatory compliance, asset-liability mismatches, and market volatility, banks must navigate
a complex landscape of risks to maintain financial stability and resilience.

Despite the challenges, effective liquidity risk management is essential for banks to safeguard
the interests of depositors, investors, and other stakeholders, as well as to ensure the stability
and integrity of the financial system. By implementing robust risk identification, measurement,
monitoring, and mitigation practices, banks can enhance their ability to withstand liquidity
stress events and maintain confidence in their liquidity positions.

Moreover, collaboration with regulators, industry peers, and other stakeholders is vital for
promoting transparency, enhancing market resilience, and addressing systemic liquidity risk
concerns. By addressing liquidity risk issues comprehensively and proactively, banks can
strengthen their risk management frameworks, optimize their liquidity positions, and contribute
to the stability and sustainability of the banking sector as a whole.

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BIBLOGRAPHY

https://www.icicidirect.com/ilearn/stocks/articles/liquidity-risk

https://unacademy.com/content/bank-exam/study-material/general-awareness/indian-
banking-system/

https://www.ibef.org/industry/banking-india

https://timesofindia.indiatimes.com/blogs/kembai-speaks/emerging-challenges-of-liquidity-
risk-management-in-banks/

https://www.investopedia.com/terms/l/liquidityrisk.asp.

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