Liquidity Risk in Banks

Professor Prashanta Kumar Banerjee, Ph.D.

 Risks in Treasury Management
1. Market Risk : Liquidity Risk,
Interest Rate Risk/ DIBOR, Foreign
Exchange Risk and Equity Risk

1.Funding Risk

3.Credit Risk

4.Compliance Risk
 1. Liquidity Risk in Bank

The ability to meet banks’ financial

obligations as they come due is called
liquidity of a bank. We have seen
major changes in the financial services
industry worldwide in the past two
decades, with many new competitors
vying for the deposits. Growth in
mutual funds, money market funds,
equity markets and the like have lured
core deposits out of banks.
 1. Liquidity Risk in Bank
On the other hand, reasonably strong
economic growth of a Developing
country enhances the demand of loans
and advances. It causes loan-to-deposit
ratios among banks to reach historic
highs consequently liquidity of the banks
was in problem for a short period
recently.
 2. Liquidity Risk
Management

Possible Needs of Liquidity Shall be Measured

2.1.
Keeping in View:

• Replacing the net cash outflow of funds

• Compensating for the Non –receipts of
expected cash flows
• Meeting the contingent Liabilities
• Undertaking a new Transaction
 Liquidity Risk Management
Inflows and Outflows of Funds to be Covered in
Cash Flow Analysis Chart
• Net Inflows of Deposits ( After netting maturities/premature
closure of deposits)

• Net outflows of advances( After netting expected

payments/premature closure of loans)

• Net outflow of investments (after netting of maturing investments/

disposal of securities)

• Inter-bank obligations/ claims

• Other liquidity options available such as swaps, reverse repos,

bills rediscounting etc.
Estimation of Liquidity Gaps
Estimation of liquidity gaps can be made for the next 3
months as under:
Next Day
1-7 days
8-29 days
30-90 days
Liquidity Policy
Deposit mix : Different percentage mix of:

Term Deposits
Demand Deposits
- Savings Bank Deposit
- Current Account Deposits
- Others
Balancing funding costs and opportunity costs by
Treasury .
Liquidity Policy…..continue
Pattern of Deposit : As long term interest pattern is
difficult to estimate, banks may discourage long term
maturity deposits beyond 3 years through interest rate
structure.

Reducing dependence on Purchased Funds like Inter

Bank funds, Call Borrowings, C.D.s up to 90 days except to
meet the immediate liquidity requirements.
Liquidity Policy…..continue
The bank will endeavor to diversify its liabilities
among markets, instruments and customer segments.
The bank will maintain a continuous market presence
and increase its customer-funding base.
The bank will review the dependence on the various
liability categories at periodic intervals to monitor the
excess dependence on a particular liability category.
Bank will ensure compliance with all BB guidelines
for maintaining liquidity and other specified ratios.
 Areas to Be Known

•CRR
•SLR (TB, Cash in Tills, FCY and LCY in BB, Selected Govt. Bonds)
•Credit Deposit Ratio (CDR) and Its
Composition
•GAP and Duration Analysis
•Monetary Policy
•Fiscal Policy
•Funded and Non- Funded Activities
•Foreign Exchange Reserve
Limit for Money Market Operation and
Investment Portfolio

1.Call Money Lending (25% of the

Owned Funds for a fortnight).
2.Call Borrowing Limit (100% of the
Owned Funds or 2% of Deposit)
3.Trading Limit for Single Ticket
4. REPO Transaction
II.
 Liquidity : Practical Issues
•Demand for liquidity and supply of
liquidity are rarely equal in a particular
point of time.

•Trade off is required between bank

liquidity and profitability.
Changing Reserve and Money Multiplier
Impact
•Bangladesh Bank may fix CRR and SLR
amount as part of its monetary policy .

•Changes of reserve creates excess

Reserve .

•Excess reserve have the multiplier Impact.

 Treasury Bills and Bonds

•Money Market Instruments

•28 -day BB Bill,
•91-day T-Bills
•182-day T-Bills
•& 364-day T-Bills
•Bangladesh Bank Bill

•Capital Market Instruments

2-year Treasury Bonds
•5-yr Treasury Bonds,
•10-yr Treasury Bonds,
•15-yr Treasury Bonds
•20-yr Treasury Bonds
Money Market Instruments
1.REPO :
• Repo with Bangladesh Bank / Rate is low
• Special Repo with Bangladesh Bank/
Rate is high
• Inter-Bank Repo
2. Reverse REPO with Bangladesh Bank
3.Call Market
4.Assured Liquidity Support (ALS)
Problems Faced by the Commercial Banks

•Excess Bills and Bonds over Stipulated

Amount for SLR
•Almost Inactive Secondary Market
• Less Coupon (BGM/BPC)
•Assumed Liquidity Support (ALS) for Two and
a Half Months (7.2%)
•Low Rate in Call Market
Suggestions for Solving the Problems

• Creation of Buyers
• Active Secondary Market
• Justifiable Coupon on the Basis of Credit Rating
• Creation of ‘Discount and Finance House’ to impart
liquidity in the money market. It could be set up jointly
by the BB and Banks
• Offer Innovative Products (Money Market Mutual
Funds , Commercial Paper, certificate of Deposits)
• Attract NRBs to buy
 Treasury Division
Head Office, Dhaka

CONTINGENCY ACTION PLAN TO MANAGE STRESSES LIQUIDITY

Local Book
Money Market
•Term Deposit
•Call Money
•Repo
Central Bank (Marketable Securities and Reserve Portfolio)
•Repo of Treasury bills
•Encashment of surplus balance with Central Bank
Other
•Cash in hand
FCY Book
Money Market
•Term Deposit
•Utilization of surplus Nostro balances
 Treasury Division
Head Office, Dhaka

QUANTIFICATION OF AMOUNT OF CONTINGENCY FINDS – LOCAL

CURRENCY

Sources of contingency funds during stressed Estimated Maximum Cost to

liquidity Available Funds …………………..
(Hypothetical)

Money Market 500 12.00%

Term Deposit
Central Bank (Marketable Securities and
Reserve Portfolio) 900 9.00-10.00%
Repo facility for treasury bills 500 6.00%
Rediscounting window 20 0.00%
Balance with CB (Excess of CRR)

Other
LCY Cash in hand 50 0.00%
 Treasury Division
Head Office, Dhaka

QUANTIFICATION OF AMOUNT OF CONTINGENCY FINDS –

Foreign currency

Sources of contingency Formula / Estimated Cost TO

funds during stressed Parameters for Maximum
Basis
liquidity Available
Calculation
Funds
(Hypothetical
Money Market LIBOR+0.50bps USD 5 Million 2.00-3.50%
(Marketable Securities)
Inter Bank Deposits
BDT 120
Reserve USD 2 Million 1.25%-1.75%
1 Month Libor
(@ 60 million)
Excess Reserve and Money Multiplier
Impact
•Suppose, banks hold $100 billion of transaction
deposits and total reserves of $ 30 billion. Assume that
the minimum reserve requirement is 20 per cent. Then
required reserve requirement is $ 20 billion. But actually
banks are holding $ 30 billion. Then excess reserve =
total reserve – required reserves = $ 10 billion.

•The existence of excess reserves implies that banks

are not fully utilizing their lending power.

•With $ 10 billion of excess reserves and the help of the

money multiplier (1 ÷ required reserve ration) the banks
could lend an additional $ 50 billion.
III. Reasons for the liquidity crisis, if it happens :

1.Unstable money market .

2.Enhancement of liquidity requirements.
3.Inefficiency in fund management – borrowing
short term but lending for long term.
4.Lack of performance in management of
liability over assets.
5.Illegal business of the commercial banks in the
capital market.
IV. Initiative Could Be Taken be Taken by the
banking sector in this situation

1.Infusing money through REPOs.

2.Increasing foreign currency reserve.
3.Collecting more deposit giving higher rate of
interest.
4.Central bank support through infusing local and
foreign currencies.
V. How to screen and manage the liquidity of the
bank.

1.Follow the circulars of the Bangladesh Bank (BB).

2.Persistently maintain liquidity requirements.
3.Maintain the loan –deposit ratio as per the standard.
4.Issue different money and capital market instruments.
5.Use money market instruments available in the
market.
6.Keeping foreign currency reserve.
VI. Calculating Process of CRR:

1. Balance with BB and its Agents *100

Time and Demand Deposit

(Calculated results 6.5% means banks efficiently

manage their liquidity)
VII. Calculating process of SLR:

Balance with Central Bank and its Agents, and Easily Liquid able Assets *100
Time and Demand Deposit

(If calculated ratios equal to or exceed 19.5, it means

banks’ liquidity is good. However for the Islamic
Banks these ratios is 10.5 per cent)
VIII. Calculating Process of Loan – Deposit Ratios

Total Loans and Advances * 100

Time and Demand Deposit

(If calculated ratios equal to or less than 80.5 (100-

19.5), it means banks lending follows the standard rules.
Notable that flexibility is necessary in calculating these
ratios)
Screening of Loan Deposit Ratio
Say : 25% on account of Term Loan
15% on account of rural advances and micro
enterprise loan
15% on account of export and import finance
Remaining 27% on account of working capital and
other demand loan .
IX. Money Market

1. Important Features of Money Market

•A loan or security maturing within one year or less is

considered to be a money market instrument.
•It provides governments short-term funds in lieu of tax
collection.
•It enables economic units (banks and corporate units)
to manage their liquidity positions.
2. Instruments available in Money Market

Money market is comprised of following non-securities

and securities instruments.

Non-Securities Securities
Cash Credit Treasury Bills
Bank's Overdraft REPOs
Call Market Reverse REPOs
Short Term Deposit Commercial Paper
Certificate of Deposits
Trade Bills
3. Principal Suppliers and Users of Money Market
Funds

Suppliers Users
Commercial banks Government
Individuals and Business units
institutions
4. Money Market of a Developing Country

•Money market is not diversified enough.

•Business units collect short-term finance from banking
channel through only non-securities instruments.
•One important money market instrument used by
business units for their liquidity purpose is commercial
paper which is not commonly used in developing
countries.
•Treasury bills are used by the Government in managing
funds for short-term purpose in lieu of tax collection. On
the other hand, treasury bills are used by banks and
financial institutions in meeting their liquidity
requirements.
4. Money Market of a Developing Country

•Call money market is used by banks and financial

institutions for their lending and borrowing purpose.
•REPO and Reverse REPO are now used in many
developing countries to make money market more
diverse. It helps to ease the pressure on liquidity and
restored the stability in market.
• Many new instruments and the new arrangements are
gradually introduced to upgrade the money market
with added depth, liquidity and interest rate flexibility.
 X. An exercise: Trade Bank
Balance Sheet December 31, 2010
Property and Assets
Cash 725
Cash e with BB 2,956
Balance with other banks 4,553
Investment Property 9,827
Loans and Advances to Customers 58, 607
Others 5384
Total Assets 82,052
Liabilities and Capital
Deposits from Banks 9, 213
Deposits from Customers 56,425
Other Liabilities 4,331
Shareholders’ Equity 12,083
Total Liabilities and Shareholders’ Equity 82,052

Suppose you work in the Asset and Liability Management department of the Bank. Do you feel, this
bank accurately manage the liquidity of the bank .If your answer is yes, justify your answer and if no
again put your logics. In answering your questions, consider relevant circulars of Bangladesh Bank.
Put suggestions, if you have any innovative idea in managing liquidity of the bank.
 Exercise -2

If Central Bank intends to restrict money supply it may raise reserve

requirement 20 per cent to 25 percent. Then the result will emerge as
follows:

Required Reserve Ratio

20 percent 25 percent
1.
Total deposits $ 100 billion $ 100 billion
2.
Total reserves $ 30 " $ 30 "
3.
Required reserves $ 20 " $ 25 "
4.
Excess reserves $ 10 " $5 "
5.
Money multiplier 5 4
6.
Unused Lending $ 50 billion $ 20
capacity