Functions of Liquidity

Liquidity risk arises on account of bank’s inability to meet its payment obligations as and when
they are demanded. The deposits of banks as liabilities and loans and advances as assets of the
bank are the prominent items in a bank’s balance sheet. The types of deposits held and the
interest rates offered on these deposits on the one hand and the types of loans and advances
sanctioned and the interest rates charged on the other hand may not match. In view of this
liquidity risk is encountered by the banks.

Liquidity risk has three components, namely funding risk, timing risk and call risk. Stagnant deposit
position and increasing demand for loans and advances create problems for the bank. If the bank
reduces interest rates on deposits it results in flying of deposits to competing banks. To increase
returns more term loans are sanctioned and the bank’s ability to collect these loans will affect its
profitability. In this sense there is conflict between profitability and liquidity. Banks have to
strike a balance between these two matching the composition of assets and liabilities. Many
times banks acquire short term deposits and try to use them for funding there long term assets.
These are termed as CASA funds implying usage of current and savings account deposits. This
affects the liquidity position of the banks.

The ability of the banks to raise funds depends on its area of operation, customer profile,
ownership of the bank and public image of the bank.

In order to mitigate liquidity risk banks have to review on a continuous basis the changes in its
deposit structure and loans and advances. To improve its liquidity it has to look at possibilities of
extending maturity on its deposits through renewals and reducing long term loan commitments. It
has to look at the reliability of assets in terms of recoveries from borrowers and sale of
investments.

The action plan for liquidity risk management should focus on its core activity of deposit
mobilization and credit sanctioning and the related risk factor that is interest rate risk should also
be considered. Such an action plan should look at short term and long term implications of the
banking functions and devise strategies to reduce liquidity risk and increase bank returns.

Short term strategies include working funds approach and cash flow approach. Long term
strategies aim at asset and liquidity management.

Reserve Bank of India has issued guidelines for liquidity management in banks. It calls for
fortnightly statement of structural liquidity and fortnightly statement of short term dynamic
liquidity. These statements aim at collecting details of changes in the deposit and loans and
advances up to a period of 90 days. This helps in understanding liquidity position of the bank.
RBI Format – Dynamic Liquidity

1‐14 15‐28 days 29‐90

days days

A. Outflows

Net increase in loans and advances

Net increase in investments

(i) Approved securities

(ii) Money market instruments (other than treasury bills)

(iii) Bonds/debentures/shares

(iv) Others

Inter‐bank obligations

Off‐balance sheet items (repos, swaps, bills discounted)

Others

Total outflows

B. Inflows

Net Cash position

Net increase in deposits (less CRR obligations)

Interest on investments

Inter‐bank claims

Refinance eligibility (Export credit)

Off‐balance sheet items (reverse repos, swaps,

bills discounted)

Others

Total inflows

C. Mismatch (B – A)

D. Cumulative mismatch

E. ( C) as a percentage to total outflows

Liquidity Functions of Banks
 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
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
 Time Buckets

• 1-14 days
• 15-28 days
• 29 days to 3 months
• Over 3 months to 6 months
• Over 6 months to 1 year
• Over 1 year to 3 years
• Over 3 years to 5 years
• Over 5 years
 Short term Dynamic Liquidity

• Fortnightly statement of outflows and inflows of assets

and liabilities for a period of 90 days.

• Time Buckets
– 1-14 days
– 15-28 days
– 29 days to 3 months

• Mismatch / cumulative mismatch as a percentage of the

total outflows
 RBI Format – Dynamic Liquidity
1-14 days 15-28 days 29-90 days
A.Outflows
Net increase in loans and
advances
Net increase in investments
(i) Approved securities
(ii) Money market instruments
(other than treasury bills)
(iii) Bonds/debentures/shares
(iv) Others
Inter-bank obligations
Off-balance sheet items
(repos, swaps, bills
discounted)
Others
Total outflows
 RBI Format – Dynamic Liquidity

1-14 days 15-28 days 29-90 days

B. Inflows
Net Cash position
Net increase in deposits (less
CRR obligations)
Interest on investments
Inter-bank claims
Refinance eligibility (Export
credit)
Off-balance sheet items
(reverse repos, swaps,
bills discounted)
Others
Total inflows
 RBI Format – Dynamic Liquidity

1-14 days 15-28 days 29-90 days

C. Mismatch (B – A)

D. Cumulative mismatch

E. ( C) as a percentage to
total outflows
Liquidity Risk
 Accounting Ratios in Liquidity Management
• Loans and Advances to Total Assets.

• Desirable maximum level from the liquidity management

angle

– 60% to 65%.

• Implications

• If greater than desirable, bank’s funds could be over tied-up in

loans and advances.

• Liquidity position would be comfortable when banks hold

within the desired limits.
 Accounting Ratios in Liquidity Management
• Loans and Advances to Core Deposits.

• Desirable maximum level from the liquidity management

angle
– 70% to 75%.

• Implications
• If very less, it may indicate an imbalance from the
liquidity
angle, as considerable portion is funded by non-core
deposits.

• If higher than desired levels the bank may not be able to meet
sudden fluctuations in its regulatory requirements.
 Accounting Ratios in Liquidity Management
• Large deposits to earning assets.
• Desirable maximum level from the liquidity management
angle
– 50% to 60%.
• Implications
• In case the percentage is very high, a sudden deposit
withdrawal may affect the earning assets.
• Since resources have to be mobilized at a higher cost if
needed on an immediate requirement to fund the earning
assets it may not be profitable for the bank.
 Accounting Ratios in Liquidity Management
• Bank liabilities without deposits to total assets.

• All liabilities except customer deposits

– Proceeds of rediscounting of bills/ instruments
– Refinance funds
– Inter bank call money borrowings

• Desirable maximum level from the liquidity management

angle
– 10% to 15%

• Implications

• Indicates the temporary source of fund for the bank.

• High level may indicate excessive dependence on this source

for managing the assets.
 Accounting Ratios in Liquidity Management

• Cash Ratio
• Cash and balances with RBI / other banks and short
term investments to total liabilities.
• Desirable minimum level from the liquidity management
angle
– 30% to 40%
• Implications
• Safety signal for the banks.
• Very high holding would reduce profitability.
 Accounting Ratios in Liquidity Management

• Loan losses to net loans.

• Desirable maximum level from the liquidity management

angle
– 1% to 2%

• Implications

• Indicates the quality of assets held by the banks.