Liquidity Risk

 Funding risk – Liability maturity structure

 Timing risk – Reutilization of funds

 Call risk – Off-balance sheet obligations

 Liquidity Management

 Reserve Bank of India

◦ Ability to efficiently accommodate deposit and other
liability decreases as well as loan portfolio growth and
the possible funding of off-balance sheet items
◦ Funding through deposits
◦ Liability side management
◦ Asset side management
◦ Managing off-balance sheet transactions
 Liquidity Risk for Banks

 Bank faces a stagnant deposit portfolio while demand for

loans and advances from corporate sector increases
Or
 Bank is required to increase the asset base to meet its
increased overheads
 Mismatch of the composition of assets and liabilities
 Short term liabilities are used to fund long term assets
 Conflict in Liquidity Risk Management

 Pricing of assets and liabilities determines the short term

problems in liquidity management for banks
 Balancing returns in relation to fund requirements is the core of
liquidity management
 If liabilities are priced less (rate of interest on a deposit in a bank
is lower than that of other peer level banks), there will be more
outflow, assuming assets (loans and advances, investment)
remain at the same level
 Conflict in Liquidity Risk Management

 If liabilities are priced low (rate of interest on bank deposit is

lower than other banks), the bank will face shortage of inflow,
assuming asset demand remains the same

 An ideal balance is to be maintained between the levels of

liabilities and assets so as to avoid the liquidity trap
 Focal Areas for Banks in Liquidity Management

 Composition of liabilities, particularly the level of demand

liabilities (current accounts and saving bank accounts) in
relation to term liabilities (fixed deposits)

 Build up of assets, particularly the level of term assets

(term loans beyond 3 years and investments in long term
securities to be held till maturity) in relation to short term
assets net of non-performing assets (cash credit,
overdrafts, demand loans)
 Focal Areas for Banks in Liquidity Management

 Predominant area of operation

 Dominant customer profile of the bank

 Ownership of the bank (Government holding,

Institutional holding, Public holding)

 Public image of the bank

 Action Plan

 Realistically assess on an ongoing basis the likely inflow

of deposits and likely demand for bank loans and also
the bank’s own policy towards investment in securities

 Possibility of renewal of maturing liabilities (fixed

deposits) and core deposits in current liabilities (current
accounts, savings bank account) as also of revolving
assets (cash credit, overdraft)

 Reliability of assets (recovery from borrowers on

demand and sale of investment and other assets when
necessary)
 Action Plan

 Ability to utilize opportunities arising in the banking

system

 Likelihood of a larger outflow of deposits may arise if the

bank’s image is tarnished or a scam has occurred in a
bank or there is a sudden change in the public
perception

 Top priority to relationship with bank customers so as to

build and maintain confidence in the bank
 Action Plan

 Funding requirement of the bank to be assessed on a

daily basis keeping in view likely future inflows and
outflows

 Classifying assets and liabilities over the applicable time

buckets

 Ability of the bank to function on a conservative basis to

meet an adverse situation that may occur at any point of
time
 Action Plan

 Ability of the bank to maintain its investment in securities

and avoid distress sale on account of liquidity crisis

 Ability of the bank to avoid high cost borrowing from the

Reserve Bank and other market borrowings on a
frequent basis
 Managerial Actions in Liquidity Management

 Core activity
◦ Pricing of assets and liabilities

 Related problem
◦ Interest risk management
 Tools for Liquidity Management

 Short term implications

 Long term implications

 Short Term Implications

 Working Funds Approach

 Cash Flow Approach

 Working Funds Approach

 Bank resources:
◦ Owned capital
◦ Deposits
 Volatile deposits (30 days) Full Liquidity
 Vulnerable deposits (core / non-core)
 Core funds
◦ Float funds Full Liquidity
 Transit funds
 Funds on issue of drafts / pay orders / cheques
 Cash Flow Approach

 Estimation of anticipated deposit base

 Likely quantum of recycling of funds that have been lent
(includes loan recovery of non performing assets)
 Assessment of quantum of maturity of deposits and
withdrawals
 Likely amount of deployment in loans and advances or
investments
 Computation of liquidity level for a specific period with a
variance level of 10 to 15%
 Long term Implications

 Asset Management

 Liquidity Management
Reserve Bank of India Guidelines on Liquidity
Management

 Fortnightly statement of structural liquidity

 Fortnightly statement of short term (up to 90 days) dynamic

liquidity
 Statement of Structural Liquidity

 Statement on the basis of liabilities and assets on the

last reporting Friday

 Time buckets on the residual maturity of each item of

assets and liabilities
 What is risk tolerance and costs of emergency
actions?
 What future scenario(s) should be assumed?
 How is information about potential future cash

flows aggregated and analysed?

 What are suitable indicators of the liquidity
 position of firms relying primarily on liability

management?
Sources of liquidity exposures
 On balance sheet
 Deposit outflows, debt maturities, loan fundings

etc
 • Off balance sheet
 Collateralisation
 Standby/Liquidity support facilities
 Derivatives
 Pipeline business
 Revolving credit facilities
 Liabilities on bill acceptances
Three levels of liquidity management
 Operational – management of intra-day and

next/near day positions Cash flows, central

bank account positions, interbank markets,
central bank access Systems for aggregating
information
 – Limits on mismatch positions for future days
 Tactical – short term unsecured funding and

asset liquidity
 Strategic – funding/capital markets access
 Bank management must understand the
sensitivities of their funds providers, the
funding instruments they use, the
relationship of funding costs to asset yields,
and any market or regulatory constraints on
funding
 In order to accomplish this, management
must understand the volume, mix, pricing,
cash flows, and risk exposures stemming
from its bank’s assets and liabilities, as well
as other available sources of funds and
potential uses of excess cash flow.
 Management must also be alert to the risks

arising from concentrations in funding

sources.
Under normal conditions and with appropriate
management planning, neither net deposit
withdrawals nor the exercise of loan
commitments poses significant liquidity
problems for DIs because borrowed funds
availability or excess cash reserves are
adequate to meet anticipated needs.
For example, even in December and the
summer vacation season, when net deposit
withdrawals are high, Dis anticipate these
seasonal effects by holding larger than
normal excess cash reserves or borrowing
more than normal on the wholesale money
markets
 Major liquidity problems can arise, however, if
deposit drains are abnormally large and
unexpected. Abnormal deposit drains (shocks)
reasons:
 Concerns about a DI’s solvency relative to

those of other DIs.

 Failure of a related DI leading to heightened

depositor concerns about the solvency of other

DIs (the contagion effect).
 Sudden changes in investor preferences

regarding holding nonbank financial assets

(such as T-bills or mutual fund shares) relative
to deposits.
 demand deposit contracts are first-come,
first-served contracts in the sense that a
depositor’s place in line determines the
amount he or she will be able to withdraw
from a DI.
 demand deposit contracts are first-come,
 first-served contracts in the sense that a

depositor’s place in line determines the

 amount he or she will be able to withdraw

from a DI.
 Rationally seek to withdraw their funds
immediately when they observe a sudden
increase in the lines at their DI
 two major liquidity risk insulation devices are
deposit insurance and the discount window.
 depository institutions have established

guarantee programs offering deposit holders

varying degrees of insurance protection to
deter runs.
 deposit insurance, central banks, such as the
Federal Reserve,
 have traditionally provided a discount window

facility to meet DIs’ short-term

 nonpermanent liquidity needs
 central banks, such as the Federal Reserve,

have traditionally provided a discount window

facility to meet DIs’ short-term
nonpermanent liquidity needs.
 Primary credit is available to generally sound
depository institutions on a very short-term
basis, typically overnight, at a rate above the
Federal Open Market Committee’s (FOMC’s)
target rate for federal funds.
 Seasonal credit is available to depository
 institutions that can demonstrate a clear
pattern of recurring intrayearly
 swings in funding needs. Eligible institutions
are usually located in agricultural
 or tourist areas.
 has effectively deterred bank panics since
1933, Depository institutions are not the only
FIs exposed to liquidity risk or run problems.
 Like DIs, life insurance companies hold cash

reserves and other liquid

 assets to meet policy cancelations

(surrenders) and other working capital needs

 that arise in the course of writing insurance.