Liquidity Management

Module D: Balance Sheet Management

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Bank Financial Management: Liquidity Management

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Contents
Coverage:
1. Introduction

2. Definition
3. Dimensions and Role of
Liquidity Risk Management
4. Measuring and managing
liquidity risk

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1.

INTRODUCTION

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Liquidity
Objectives of Asset Liability Management:
Ensuring profitability
Ensuring liquidity

Liquidity
Represented by quality and marketability of assets and liabilities
Exposes the organisation to liquidity risk
Liquidity risk is a normal aspect of everyday management of a financial
institution. Very rarely result in solvency risk problems

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2.

DEFINITION

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Liquidity
Required to meet deposit withdrawals and to fund loan
demands
To compensate for expected and unexpected balance sheet
fluctuations
Provide funds for growth

Represents the ability to accommodate decreases in liability

and to fund increases in assets

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3.

DIMENSIONS AND ROLE OF

LIQUIDITY RISK MANAGEMENT
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Liquidity Management
Process of generating funds to meet contractual or
relationship obligations a reasonable prices at all times
New loan demands, existing commitments, and deposit
withdrawals are the basic contractual or relationship
obligations that a bank must meet

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Functions of Liquidity Management

Demonstrates to the market place that bank is safe and
has repayment capacity
Enables to meet its prior loan commitments formal or
informal
Enables bank to avoid unprofitable sale of assets
Lowers the size of the default risk premium
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Adequacy determined by analysing

Historical
Funding
requirements

Current
Liquidity
Position

Anticipated
future funding
needs

Sources of
funds

Options for
reducing
funding needs

Present and
anticipated
asset quality

Present and
future earnings
capacity
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Present and
planned capital
position

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Factors affecting Bank liquidity

Decline in
Earnings

Increase in
NPAs

Deposit
Concentrations

Downgrading
by rating
agencies

Expanded
business
opportunities

Acquisitions

New tax
initiatives
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How to meet funding requirements?

Dispose of
Liquid Assets

Increase short
term
borrowings

Decrease
holdings of less
liquid assets

Increase
liabilities of a
term nature

Increase capital
funds

Securitisation
of Assets

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Types of Liquidity Risks

Based on source of origin:

Internal
Perception
of
Institution
in various
markets
Local
Regional
National
International

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External
Geographic

Systemic

Instrument
Specific

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Types of Risks
Funding Risk
Need to replace net
outflows due to
unanticipated
withdrawals/non-renewal

Time Risk
Need to compensate for
non-receipt of expected
inflows of funds

Call Risk
Crystallization of contingent
liability

Arises due to:

Arises due to:

Arises due to:

Fraud Causing substantial loss

Systemic risk
Loss of Confidence
Liabilities in Foreign Currencies

Severe deterioration in asset quality

Standard assets turning into NPA
Temporary Problem in recovery
Time involved in managing liquidity

Conversion of non-fund based limit

to fund based limit
Swaps and Options

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4.

MEASURING AND MANAGING

LIQUIDITY RISK
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Elements of strong liquidity management

Good management
information system

Central Liquidity
control

Diversification of
funding sources

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Analysis of net
funding
requirements under
alternative scenarios

Contingency
Planning

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Steps necessary for managing liquidity risks

Developing a
structure for
managing liquidity
risk

Setting tolerance
level and limit for
liquidity risk

Measuring and
Managing Liquidity
Risk

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Developing a structure for managing

liquidity risk
Liquidity Risk Management Involves
Setting a strategy for the bank ensuring effective board and senior
management oversight
Operating under a sound process for measuring, monitoring and
controlling liquidity risk

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Strategy should

Set out general approach to liquidity including quantitative and qualitative

targets

Address banks goal of protecting financial strategy and ability to

withstand stressful events

Enunciate specific policies on particular aspects of liquidity management

Be communicated throughout the organisation

-----

Board should monitor performance and liquidity risk profile of bank

Bank should have a liquidity management structure in place

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Treatment of Foreign Currencies

Adds complexity to liquidity management as:
1.

Banks less well known to liability holders in foreign currency markets

who may not be in a position to correctly assess domestic market
situations

2.

In the event of disturbance bank may not be able to mobilise

domestic liquidity to meet foreign currency funding requirements

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Treatment of Foreign Currencies

Management must make two key decisions:
1.

Management Structure:
i)

Complete Centralisation of Liquidity management

ii) Decentralise by assigning operating divisions responsibility for their

liability subject to limits imposed by HO or frequent/routine reporting to
HO
iii) Responsibility for liquidity in home currency and overall coordination to
home office and responsibility for banks global liquidity in major foreign
currencies to the management of foreign office in the country issuing the
respective currency

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Treatment of Foreign Currencies

2. Liquidity strategy in each currency:
Banks assessment will depend upon:

Funding needs

Access to foreign currency funding market

Capacity to rely on off balance sheet instruments (SBLC, Swaps etc)

Bank must also develop a back-up liquidity strategy

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Setting tolerance level and limit for

liquidity risk

Limits could be set on the following lines:

Cumulative cash flow mismatches over particular period taking conservative view of
marketability of liquid assets
Liquid assets as percentage of short-term liabilities
A limit on Loan to deposit ratio
A limit on loan to capital ratio
Limit on relationship between anticipated funding needs and available sources

Primary sources for meeting funding needs should be quantified

Flexible limits on %age reliance on a particular liability category
Dependence on individual customers and market segments
Flexible limits on min/max average maturity of different categories of liabilities
Minimum liquidity provision to be maintained to sustain operations

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Measuring and Managing Liquidity Risk

Approaches:
1. Stock Approach
2. Flow Approach

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Stock Approach

Based on the level of assets and liabilities as well as Off-Balance sheet

exposures on a particular date
Ratio of Core Deposit to total Assets:
Core Deposit/Total Asset
More the ratio better it is because core deposits are stable sources of liquidity.
Net Loans to Total deposits Ratio:
Net Loans/Total Deposit
It reflects the ratio of loans to Public Deposits or core deposits. Lower the ratio is the better.
Ratio of Time Deposits to Total Deposits:
Time Deposits/Total Deposits
Higher the Ratio better
Ratio of Volatile liabilities to total assets
Volatile Liabilities/Total Assets
Lower the Ratio the Better

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Stock Approach
Ratio of Short Term Liabilities to Liquid Assets:
Short Term Liabilities/Liquid Assets:
Lower the Ratio the better
Ratio of Liquid Assets to Total Assets:
Higher the Ratio the better
Ratio of Short Term Liabilities/Total Assets:
A lower ratio is desirable
Ratio of Prime Asset to Total Asset:
Higher the ratio the better
Ratio of Marketable liability to total asset:
Lower the ratio better

Indian Banks do not follow this approach

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Flow Approach
Also known as Gap Method
Three major dimensions:
1.

Measuring and Managing net funding requirements

2.

Managing market access

3.

Contingency Planning

Requires preparation of structural liquidity gap report

Calculated on the basis of residual maturities of assets and
liabilities
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Measuring and Managing net funding

requirements
Analysis of net funding requirements involves construction of
a maturity ladder and calculation of a cumulative net excess
or deficit of funds at selected maturity dates
Banks net funding requirements are determined by analysing
its future cash flows based on assumptions of the future
behaviour of assets, liabilities and off balance sheet items,
and then calculating the net excess over the time frame of
liquidity assessment
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Aspects

Maturity Ladder
Alternative Scenarios
Measuring liquidity over the chosen time frame
Assumptions used in determining cash flows

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The Maturity Ladder

To compare a banks future cash inflows to its future cash outflows
over a series of specified time periods
Inflows arise from
Maturing assets
Saleable non-maturing assets
Established credit lines that can be trapped

Outflows include
Liabilities falling due
Contingent liabilities, especially committed lines of credit that can be
drawn down
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The Maturity Ladder

Bank has to allocate each cash flow to a given date
Cash inflows can be ranked by the date on which assets mature or a
conservative estimate of when credit lines can be drawn down
Cash outflows can be ranked by the date on which liabilities fall due,
earliest date a liability holder could exercise an early repayment

option or the earliest dates contingencies can be called

Significant interest and other cash flows should also be included

The gap for a specific period may thereafter be measured

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Alternative Scenarios
General Market
Conditions
Benchmark for the
normal business
behavior of the
balance sheet
Useful in managing a
banks use of
deposits and other
debt markets

Bank Specific Crisis

A type of worstcase benchmark
Many of the banks
liabilities could not
be rolled over or
replaced and would
have to be repaid at
maturity so that the
bank would have to
wind down its books
to some degree

General Market Crisis

Liquidity is affecting
all banks in one or
more markets
Differences in
funding access
amongst banks or
among classes of
financial institutions
would widen
Second type of
worst-case
benchmark

Judgment often plays a large role, especially in crisis scenarios

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Measuring liquidity over the chosen time

frame
A stylised liquidity graph can be constructed, enabling the
evolution of the cumulative net excess or deficit of funds to
be compared under the three scenarios to provide further
insights into a banks liquidity and to check how consistent
and realistic the assumptions are for the individual bank

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Assumptions used in determining cash

flows
Assumptions regarding assets
Potential Marketability (Most Liquid, Less Liquid, Least Liquid)
Use of existing assets as collateral
Extent to which maturing assets will be renewed
Acquisition of new assets
Assumptions regarding liabilities
Level of rollovers of deposits and other liabilities
Effective maturity of deposits with non-contractual maturities
Growth in new deposit accounts
Assumptions regarding Off balance sheet activities
Level of cash outflows on crystallization of contingent liabilities
Other Assumptions
Funds to support operations
Net overhead expenses

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Managing Market Access

It is important for a bank to review periodically its efforts
to maintain the diversification of liabilities
to establish relationships with other liability holders
to develop asset-sales markets

Examine level of reliance on individual funding sources

Strive to understand and evaluate the use of inter-company
financing for individual business offices

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Contingency Planning
Should address two major questions:
Does management have a strategy for handling a crisis?
Procedures to ensure timely, uninterrupted flow of information
Clear division of responsibility
Strategy for taking certain actions to alter asset and liability behaviours
Relationships

Dealing with Press and Broadcast media

Does management

have procedures in place for accessing cash in

emergency?
Back up liquidity for emergency situations

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RBI Guidelines for maturity buckets

All Assets & Liabilities to be reported as per their maturity profile into 10
maturity Buckets:
Tomorrow
2 to 7 days
8 to 14 days
15 to 28 days
29 days and up to 3 months

Over 3 months and up to 6 months

Over 6 months and up to 1 year
Over 1 year and up to 3 years

Over 3 years and up to 5 years

Over 5 years

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Do you have any questions or queries or some feedback to give?

Just mark an email to super.msahluwalia@yahoo.com

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M S Ahluwalia, amongst other things, is a visual artist, blogger,

blog designer and of course an MBA and Banker from New
Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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