Liquidity Risk !
+Availability of Cash in the amount and at the time needed and at a reasonable cost.
+A bank is considered to be liquid if it has ready access to immediately spendable funds at reasonable cost
+Tightness is the bid-ask spread
+Depth is the volume of transactions necessary to move prices;
+Resiliency is the speed with which prices return to equilibrium following a large trade.
+Diversity is simply the degree of diversity among market participants in their market views and desired trades.
Demand for Liquidity
+Customer Deposit Withdrawals
+Credit Requests from Quality Loan Customers
+Repayment of Non-deposit Borrowings
+Operating Expenses and Taxes
+Payment of Stockholder Dividends
Supply of Liquidity
+Incoming Customer Deposits
+Revenues from the Sale of Non-deposit Services
+Customer Loan Repayments
+Sales of Bank Assets
+Borrowings from the Money Market
Bank’s Net Liquidity Position
Net Liquidity Position (Lt)=
Supply of Liquidity Flows
Demands for Liquidity
+When the bank’s total demand for liquidity exceeds its total supply of liquidity, management must prepare for a liquidity deficit (Lt<0), deciding when and where to raise additional liquid funds.
+When the total supply of liquidity to the bank exceeds its liquidity demands, management must prepare for a liquidity surplus (Lt>0), deciding when and where to profitably invest surplus liquid funds.
Essence of Liquidity Management
+Rarely are the Demands for Liquidity Equal to the Supply of Liquidity at Any Particular Moment. The Financial Firm Must Continually Deal with Either a Liquidity Deficit or Surplus
+There is a Trade-Off Between Bank Liquidity and Profitability. The More Resources are Tied Up in Readiness to Meet Demands for Liquidity, the Lower is the Financial Firm’s Expected Profitability.
Reasons for Liquidity Problems
+Imbalances Between Maturity Dates of Their Assets and Liabilities
+High Proportion of Liabilities Subject to Immediate Repayment
+Sensitivity to Changes in Interest Rates.
Strategies for Liquidity Management
+Asset Liquidity Management or Asset Conversion Strategy
+Borrowed Liquidity or Liability Management Strategy
+Balanced Liquidity Management
Asset Liquidity Management
+Reliance on liquid assets that can be sold readily for cash to meet a bank’s liquidity needs.
+When liquidity is needed selected assets are sold until all the demand for cash are met.
+Also called Asset Conversion strategy as liquid funds are raised by converting non cash assets into cash.
+Loss of Future Earnings on Assets That Must Be Sold
+Transaction Costs on Assets That Must Be Sold
+Potential Capital Losses If Interest Rates are Rising
+May Weaken Appearance of Balance Sheet
+Liquid Assets Generally Have Low Returns
Liability Liquidity Management
+Reliance upon borrowed funds to meet a bank’s liquidity needs.
+Also known as Borrowed Liquidity or Purchased Liquidity strategy.
+It calls for borrowing enough immediately spendable funds to cover all anticipated demands for liquidity.
+A bank can borrow only when there is need
+Allows a bank to keep its volume and composition of asset portfolio unchanged.
+Allows a bank using interest rate as a control variable.
+Borrowing liquidity is the most risky because of the volatility of money market interest rate.
+Borrowing cost is uncertain that adds uncertainties to bank’s net earnings.
+If the bank is in trouble in collecting funds, other institutions become less interested to lend to it and depositors begin to withdraw their funds
Balanced Liquidity Management
+Combined use of liquid asset holdings and borrowed liquidity.
+Due to inherent risk in relying on borrowed liquidity and costs of storing liquidity in assets, most bank use a combination of the two strategies.
+Under the strategy some of the expected demands for liquidity are stored in assets, while other anticipated liquidity needs are backstopped by advance arrangements for lines of credit from correspondent banks or other suppliers of funds.
Guidelines for Liquidity Manager
+The liquidity manager must keep track of all fund raising and fund using departments and coordinate with his departments and their activities
+The liquidity manager should know in advance when the bank’s big customers plan to withdraw funds or add to deposits
+The liquidity manager in cooperation with senior management and board, must make sure that bank’s priorities and objectives for liquidity management are clear.
+The bank’s liquidity needs and liquidity decisions must be analyzed on a continuing basis to avoid both excess and deficit liquidity position.
+Sources and uses of funds approach
+Structure of funds approach.
+Liquidity indicator approach.
Sources and Uses of Fund Approach
It begins with two simple facts:
+Bank liquidity rises as deposits increase and loans decrease [sources of fund]
+Bank liquidity declines when deposits decrease and loans increase [uses of fund]
+The method is for estimating a bank’s liquidity requirements by focusing primarily on expected changes in Deposits and Loans.
Sources and Uses of Fund Approach
+Whenever sources and uses of liquidity do not match, the bank has a liquidity gap, measured by the size of the total difference between its sources and uses of funds.
Positive Liquidity Gap
When sources of
liquidity exceed uses
of liquidity, the
bank will have a
positive liquidity gap
Negative Liquidity Gap
When uses of
sources of liquidity,
the bank will have a
Negative liquidity gap
Preparing Liquidity Gap
+To segregate assets and liabilities into different time buckets based on their remaining maturities
+To place all assets and liabilities in the appropriate time buckets
+To subtract maturing liabilities from maturing assets in order to determine the liquidity gap under each bucket
+To compute the cumulative liquidity gap.
Strategies for Managing Liquidity Gap
In case of positive liquidity gaps
+Shrinkage strategy: to lend funds for longer term or to invest in longer-term securities
+Liability restructuring strategy: not to renew the term deposits and accept short-term deposits
+Asset restructuring strategy: to convert the short-term securities into long-term securities
In case of negative liquidity gaps
+Growth strategy: borrowing long-term funds from the market and investing in short-term securities or increase term deposits and deploy in short-term loans
+Asset restructuring strategy: selling long-term assets and buying short-term securities
+Liability restructuring strategy: short-term deposits to be rolled over by offering high interest rate
+Contingency plan: arrange credit line from the larger banks.
Structure of Funds Approach
+The method is for estimating a bank’s liquidity needs by dividing its borrowed funds into categories based upon their probability of withdrawal.
+Hot money liabilities (Volatile liabilities)—deposits and other borrowed funds that are very interest sensitive or that management is sure will be withdrawn during the current period.
+Vulnerable funds—customer deposits of which a substantial portion will probably be removed from the bank sometime during the current time period.
+Stable funds (often called core deposits or core liabilities)—funds that management considers most unlikely to be removed from the bank
+Liquidity manager must set aside liquid funds according to some desired operating rule. For example, the manager may decide to set up a 95 percent liquid reserve behind all hot money funds. This liquidity reserve might consist of holdings of immediately spendable deposits in correspondent banks plus investments in Treasury bills etc.
Liability Liquidity Reserve =
0.95 ´ (Hot money deposits and non deposit funds – Legal reserves held) +
0.30 ´ (Vulnerable deposit and non deposit funds – Legal reserves held) +
0.15 ´ (Stable deposits and non deposit funds –
Legal reserves held)
+The bank must be ready at all times to make good loans. The bank must have sufficient liquid reserves on hand because, once a loan is made, the borrowing customer will spend the proceeds and those funds will flow out to other depository institutions.
+Total Liquidity Reserve = 0.95´(Hot money deposits and non deposit funds-Legal reserves held) + 0.30 ´ (Vulnerable deposit and non deposit funds-Legal reserves held) + 0.15 ´ (Stable deposits and non deposit funds-Legal reserves held) + 1.00 ´ (Potential Loan Outstanding- Actual Loan Outstanding)
+The above equation is subjective estimate that rely heavily on management’s judgment, experience and attitude toward risk.
Liquidity Indicator Approach
Cash position Indicator.
Core Deposit Ratio.
Deposit Composition Ratio.
Loan to Deposit Ratio.
LCR or Liquidity Coverage Ratio.