measuring and managing liquidity risk
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FIN925 Report Danial Munsoor 3259882 Zara Khan 3189727
Table of Contents Synopsis ........................................................................................................................ 1
1. Introduction ............................................................................................................. 2
2. Measuring Liquidity Risk ....................................................................................... 3
2.1 GAP Analysis ..................................................................................................... 3
2.2 Liquidity Ratio ..................................................................................................... 4
2.3 Net Loans to Total Assets Ratio ......................................................................... 5
2.4 Loans to Deposits (LTD) Ratio ........................................................................... 5
3. Managing Liquidity Risk ........................................................................................ 6
3.1 Corporate Governance ....................................................................................... 6
3.2 Strategies & Policies .......................................................................................... 6
3.3 Determining Risk Limits ..................................................................................... 7
3.4 Internal control ................................................................................................... 8
3.5 Active management of intraday liquidity positions .............................................. 8
3.6 Scenario/Stress testing ...................................................................................... 9
3.7 Contingency funding planning ............................................................................ 9
3.8 Reporting Requirements .................................................................................. 10
4. Conclusion ............................................................................................................ 11
5. References ............................................................................................................ 13
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Synopsis
Liquidity risk is the risk that arises when the company has insufficient financial
resources available to meet all its obligations and commitments as they fall due.
Therefore, the company should try to maintain adequate liquidity at all times, in all
geographic locations and for all currencies, so that it is in a position to meet all
obligations as they fall due. In order to maintain adequate liquidity at all times, the FI
must measure the risk associated with its liquidity so that it is able to provide a cushion
against the capital outflows. Some of the most common methods of measuring liquidity
risk include Liquidity GAP Analysis, Liquidity Ratio, Net Loans to Total Assets Ratio and
lastly Loans to Deposits Ratio. Liquidity risk once measures needs to be managed
appropriately. Several principles have been laid out by literature to assist banks and
other financial institutions in effectively managing the liquidity risk. These include
establishment of effective corporate governance, involvement of management in
devising risk policies, strategies and setting risk limits, internal control of the liquidity risk
management framework, active management of intraday liquidity position, stress
testing, contingency funding planning and meeting reporting requirements. All these
concepts and principles need to be well understood and implemented in banks.
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1. Introduction: Liquidity risk is the risk that arises when the company has insufficient financial
resources available to meet all its obligations and commitments as they fall due. In other
words, it is the probability of loss arising from an event where (1) there will not be
sufficient cash and/or cash equivalents to meet the needs of depositors and borrowers,
(2) proceeds from illiquid assets will yield less than their fair value, or (3) illiquid assets
will not be sold at the desired time due to lack of buyers (Business Dictionary, 2010).
The Liquidity Risk associated with Financial Institutions (FI’s) is mainly the probability
that depositors (or lenders) will want to withdraw their funds. This is referred to as the
Capital Outflow (or Deposit Drain). Such a situation mainly arises when the actual
liquidity needs are more than the predicted liquidity needs. Therefore, the company
should try to maintain adequate liquidity at all times, in all geographic locations and for
all currencies, so that it is in a position to meet all obligations as they fall due (Standard
Chartered Annual Report, 2008). If the bank or the FI is not able to meet the liquidity
requirements, it may be exposed to additional costs. It may have to cut down on its new
loans, which will adversely affect the profitability of the bank. Moreover, it may also have
to sell some of its non-liquid assets at a loss. In the worst case scenario, the bank will
not be able to provide for the agreed or the promised payment, for example the
withdrawal request will be refused or a loan commitment will not be honored. This will
reduce the confidence in the bank, and will also have a negative impact on the stability
of its financial system (Hogan, 2004: 191). Therefore, many leading financial institutions
have taken steps to enhance the visibility of liquidity risk and have also created
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integrated risk management frameworks that expand the responsibility for liquidity risk
measurement and management (Ernst and Young, 2009).
2. Measuring Liquidity Risk: In order to maintain adequate liquidity at all times, the FI must measure the risk
associated with its liquidity so that it is able to provide a cushion against the capital
outflows. There are various ways of measuring liquidity risk, but some of the primary
and most commonly used measures include:
2.1 GAP Analysis:
In order to limit our exposure to liquidity risk, banks must monitor the Liquidity Gap
between assets and liabilities in terms of maturities. Banks need to match the
maturities of the assets with the maturities of our liabilities, so that the funds become
available to the FI just as it is called upon to pay out the funds. But to achieve this
match is extremely difficult due to the different time preferences between
borrowing and lending customers (Nazneen, 2007). The sample Asset/Liability
maturity mismatch schedule shown below represents a simple way to look at the
maturity profile of a bank:
Maturity Bucket
Assets (in millions)
Liabilities (in millions)
Liquidity GAP
Cumulative Gap (CGAP) (in millions)
ID 0 0 0 0 1D - 3M 760 1060 -300 -300 3M - 6M 1200 3400 -2200 -2500 6M - 1Yr 1700 2850 -1150 -3650 1Yr - 5Yr 6100 2500 3600 -50
> 5Yr 9250 8500 1750 700
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If we analyze the bank above for a one year period, we can see that the assets due
over the period are insufficient to cover liabilities which are coming due. A negative
CGAP of $ 3,650 million for the one year period indicates that the bank is going to
face problems in funding its obligations. Therefore, the asset/liability committee must
take necessary steps to prevent this mismatch. However, the position improved
beyond 5 years, as “over the 5 Year Bucket” shows a positive CGAP of $700
million.
2.2
Liquidity Ratio:
The Liquidity Ratio measures the extent to which a bank can quickly liquidate its
assets, and pay the creditors who are seeking payment. One way to obtain this ratio
is to divide the Liquid Assets of a bank by its Core Deposits. The higher the ratio, the
better the liquidity position of a bank (Carapeto, 2010) Consider the Balance Sheet
of XYZ Bank below:
Assets $m Liabilities and Equity $m Cash in Hand 250 Current (Demand) Deposits 7000 Trading Securities (T-Notes) 1000 Savings Deposits 4300 Investment Securities 750 Time Deposits 9650 Loans to Banks 5400 Accounts Payable 400 Loans to Customers 15350 Short-term Borrowings 200 Other Assets 200 Shareholders’ Equity 1400 Total Assets 22950 Total Liabilities and Equity 22950
The Liquid Assets include Cash and Trading (Short-term) Securities which add up to
$1,250 million. The Core Deposits include Current and Savings Deposits which add
up to $ 11,300 million. Hence by using the values for Liquid Assets and Total
Deposits, we obtain a Liquidity Ratio of 11.06% which means is a risky bank,
because its liquid assets are only 11.06% of its Core Deposits. However, an
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alternative way to obtain the ratio is to divide Short-term Securities by Total
Deposits. We usually want this ratio to be high.
2.3
Net Loans to Total Assets Ratio:
This ratio is obtained by dividing Net Loans by Total Assets. It indicates what
proportion of the bank’s total assets is tied up in loans, which are illiquid assets for a
bank. The lower the ratio, the better the liquidity position of a Financial Intermediary
(Carapeto, 2010). Using the balance sheet of XYZ Bank above, we can determine
the value for this ratio. Assuming the loans to be net of Reserves for Loan losses,
we get Net Loans as $20,750 million. Thus by using the figures for Net Loans and
Total Assets we obtain a ratio of 90.41%. This indicates that the liquidity position of
XYZ is not good as 90.41% of its total assets are tied up in loans. We are usually
looking for a low Net Assets to Total Assets ratio.
2.4
Loans to Deposits (LTD) Ratio:
A bank obtains this ratio by Dividing Total Loans (Non-liquid Assets) by Total
Deposits (Liquid Liabilities), and is a good measure of liquidity risk. It is also one of
the Financial Soundness Indicator. The higher this ratio, the worse would be the
liquidity position. A LTD ratio of 99.04% for XYZ Bank indicates that XYZ is relying
heavily on its deposits, and it may also have difficulty in fulfilling the unexpected fund
requirements (Investopedia, 2010). Hence, we try for a low LTD ratio.
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3. Managing Liquidity Risk:
The tumult in the global financial markets and the credit crunch that started affecting
global operations has given financial institution’s risk management great lessons to
learn and to deal with liquidity risks in the future. Just how liquidity risk identification and
measurement is crucial, managing and controlling the determined risk holds equal
importance. Liquidity risk management assists a bank in reducing costs associated with
liquidity shortage problems. Vital rudiments of sound risk management include the
following:
3.1
Effectual corporate governance under supervision of Board of Directors should be
implemented. The board of directors are held responsible for liquidity risk than an
institution assumes. Therefore, Board should ensure risk tolerance of the institution
is recognized. BOD should also ensure that they establish lines of authority and give
responsibility to them for controlling liquidity risk while simultaneously understanding
the risk profiles of subsidiaries and affiliates as appropriate (National Credit Union
Administration, 2010).
Corporate Governance:
3.2
Liquidity strategy of a bank of a financial institution will set out the approach that is
being adopted towards dealing with liquidity. The ultimate aim of the strategy will be
to tackle bank’s objective of defending the financial strength as well as baring
stressful, critical events that occur in the markets.
Strategies & Policies:
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An Institution’s liquidity strategy will articulate the policies on specific features of
management of liquidity. These include characteristics such as composition of
assets and liabilities, the approach adopted to manage liquidity in different
currencies and countries, the degree of reliance that the institution places on certain
financial instruments and the marketability of assets. A strategy should also be
formulated and agreed upon by management to deal with temporary and long term
liquidity concerns. It is fundamental that the strategies for managing liquidity risk
should be conversed across the organization. All the divisions of the financial
institution whose activities effect liquidity of the institution should be aware of the
strategy and shall only operate under the standard policies and procedures of the
institution (Caymand Islands Monetary Authority, n, d).
One example of a strategy that a bank can adopted in diversification in sources of
funds. A general liquidity management and control practice is to restrict attention to a
particular funding source such as only wholesale funding or only retail funding. A
combination of two will provide bank with sufficient diversity to ensure that funds are
available at the right maturities at reasonable costs (Bank for International
Settlements, 2008).
3.3
Board of Directors and senior management should determine and set limits of risk
which is acceptable for the financial institution. These limits should be set based on
the strategies, past experiences, nature of the transactions that occur etc. The two
most employed methods to determine risk limits are:
Determining Risk Limits:
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(a) Dynamic Risk Limits: This determines the maximum level of cash flow mismatch
occurring at a specific period of time. An example could be ratio of cumulative net
funding requirement to total liabilities for the following day, week or month.
(b) Static Risk Limits: On the other hand, static risk limits determine ratio of minimal
level of liquid assets to short term liabilities.
Minimum risk limits that should be formulated in the policies could be for example
Loan to deposit ratio (discussed above) should not exceed 70% of total deposits
excluding borrowings and liabilities (Baker et al, 2003).
3.4
An adequate system of internal controls is crucial to the overall risk management
process. An essential element of internal control system comprises of regular
independent review and assessment of effectiveness of the current system in pace
and if necessary appropriate revisions or development must be made. When the
results of these are presented to management and supervisory authorities, they will
implement in strategies and policies and to other important variables that need
necessary adjustments (Caymand Islands Monetary Authority, n, d).
Internal control:
3.5
In order to manage liquidity risks, it is imperative for the banks and other financial
institution’s to comprehend intraday cash flows in alignment with customer’s
commotion to assist them understand the periods when funding is needed the most
and when the typical variation in this need is likely to occur. Customer’s peak credit
demands can be smoothened via imposition of overdraft limits on the customers. For
Active management of intraday liquidity positions:
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day to day management of liquidity, a strategy should be formulated and
communicated throughout the institution (Federal Financial Institutions Examination
Council, n, d).
3.6
Stress tests and scenario analysis hold immense importance in liquidity
management. Stress test or scenario testing as it is termed will identify the exposure
of a firm to liquidity risk. Regulators also place emphasis on well planned and
executed scenario testing as liquidity management tool and active involvement of
management in doing so (Barfield et al).
Scenario/Stress testing:
Laying out “what if” scenarios is like identifying the behavior of cash flows of a bank
under different conditions. The testing should be done under 2 or more scenarios
depending on the complexity and volatility of conditions. First scenario is likely to be
on-going business environment scenario while second could be the company
specific crisis taking into account both external and internal factors (Central Bank of
Barbados, 2008). Banks should utilize the results of the stress tests in order to
identify the adjustments needed to its liquidity risk management policies and
strategies and for devising effective contingency funding plans (Fiscal Policy
Research Institute, 2010).
3.7
Contingency funding plans are devised to organize banks’ strategies for covenanting
with stress scenarios. These plans will assist bank identify potential sources of funds
available to cover the shortfalls that may arise in adverse conditions. In other words,
Contingency funding planning:
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precise guidance should be provided as to understanding the relationship between
scenario testing and CFP’s and what warnings does it give to management, early
indicators, the internal and external communication of the strategies and willingness
to execute plans when needed (Institution of International Finance, 2007).
The ability of a bank’s ability to survive short and long term liquidity crises can
largely be influenced by competence of contingency plan in place. An effective
contingency plan should have following components:
(1) Persistent flow of information to senior management in a timely manner and
procedures in place.
(2) Clear understanding of who within management is to assume responsibility if a
liquidity crisis occurs.
(3) Plan in action for making amendments to composition of assets and liabilities.
(4) Back-up sources of funding should be identified including in identification of
primary and secondary sources of liquidity.
(5) Categorization of bank customers (borrowers) and other trading partners in terms
of their importance to the financial institution (Central Bank of Barbados, 2008).
3.8
As part of the reporting requirements, financial institution should report the following
to Monetary Authority:
Reporting Requirements:
(1) Submit in written a copy of their liquidity management policy.
(2) Submit on quarterly basis the attached regulatory return – Maturity Gap Analysis.
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(3) Advise about current or future liquidity of bank and the strategies that have been
devised by management to address the concerns.
These reporting requirements differ from country to country however they are crucial
to liquidity risk management for any bank or financial institution (Caymand Islands
Monetary Authority).
4. Conclusion: Despite the innumerable literature and principles on measurement and management of
liquidity risk, a lot has gone wrong in financial systems that led to the financial crisis
beginning 2007-2008. According to an article, four crucial lessons learnt from current
crisis that should assist is avoiding future problems need to be understood. Firstly, there
needs to be better understanding about the sources of liquidity risk especially under
stressed conditions. Secondly, effective contingency funding plans need to be devised
by banks. Moreover, via better disclosure of liquidity risk management policy, banks
should sustain enhanced performance of the market and stricter market regulation.
Lastly, it is important that liquidity risk management is taken to higher standards in order
to avoid costs associated with bank failure (Jenkinson, 2008).
A liquidity risk management forum was held in 2009 in UAE where opinions of experts
from different banks and institutions had participated. Dr. Saidi in the forum pointed out
that there is a need for new liquidity management norms because despite the strict
liquidity norms set by Basel and domestic regulations, current crisis spiraled around the
banking systems. He also pointed that banks need to have more effective risk
management policies in place which should be transparent to management. Joachim
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Block Group Chief Risk Officer of Emirates NBD added his opinion and advised that
having a more extensive liquidity policy is crucial to strong governance (Khaleej Times,
2009).
It is therefore evident that well formulated strategies, policies and practices needs to be
implemented along with some regulations from Central Bank to effective manage
liquidity risk.
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5. References:
• Baker & McKenzie (2003) “Audit Manual for Liquidity Risk”, Bank of Thailand [online], Available: http://www.bot.or.th/English/FinancialInstitutions/FI_Corner/RiskMgt_Manual/DocLib_DocumentForDownload/RiskManagementExaminationManaul_05_LiquidityRisk.pdf [Accessed 30th November, 2010].
• Bank for International Settlements (2008) “Principles for Sound Liquidity Risk
Management and Supervision”, Basel Committee on Banking Supervision [online], Available: http://www.bis.org/publ/bcbs144.pdf [Accessed 30th November, 2010].
• Barfield, R. & Venkat, S. (n,d) “Liquidity Risk Management”, PriceWaterHouseCoopers [online], Available: http://www.pwc.com/en_GX/gx/banking-capital-markets/pdf/liquidity.pdf [Accessed 28th November, 2010].
• Carapeto, M. (2010), ‘Distress Resolution strategies in the Banking Sector: Implications for Global Financial Crisis’ [online] Vol. 11, pp. 12, Available: Emerald [Accessed 25th November, 2010].
• Caymand Islands Monetary Authority (n,d) “Statement of Guidance – Liquidity Risk Management” [online], Available: http://www.cimoney.com.ky/default.aspx?id=0&ItemID [Accessed 26th November, 2010].
• Central Bank of Barbados (2008) “Liquidity Risk Management Guideline” [online], Available: http://www.centralbank.org.bb/WEBCBB.nsf/vwPublications/989BD4BF1C97098B0425741A00425EB3/$FILE/Liquidity_Risk_Management_Guideline.pdf [Accessed 28th November, 2010].
• Ernst and Young (2009) “Measuring and managing liquidity risk” [online], Available: http://www.ey.com/Publication/vwLUAssets/liquity-risk-brochure-1109/$FILE/liquidity-risk-brochure-1109.pdf [Accessed 28th November, 2010].
• Federal Financial Institutions Examination Council (n, d.) “Liquidity Risk” [online], Available: http://www.ffiec.gov/ffiecinfobase/booklets/wholesale/13.html [Accessed 26th November, 2010].
• Fiscal Policy Research Institute (2010) “Regulation and Supervision for Sound Liquidity Risk Management for Banks”, The ASEAN Secretariat [online], Available: http://www.aseansec.org/documents/ASEAN+3RG/0910/FR/17b.pdf [Accessed 30th November, 2010].
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• Hogan, W. (2004), Management of Financial Institutions, John Willey and Sons, Australia, pp. 191.
• Institution of International Finance (2007) “Principles of Liquidity Risk Management” [online], Available: http://www.afgap.org/documents/Divers/LiquidityPaper.pdf [Accessed 29th November, 2010].
• Investopedia (2010) “Loan to Deposit Ratio – LTD” [online], Available: http://www.investopedia.com/terms/l/loan-to-deposit-ratio.asp [Accessed 30th November, 2010].
• Jenkinson, N. (2008) “Strengthening Regimes for Controlling Liquidity Risk: Some Lesson from the Recent Turmoil”, Bank of England [online], Available: http://www.bankofengland.co.uk/publications/speeches/2008/speech345.pdf [Accessed 20th November, 2010].
• Khaleej Times (2009) “Managing Liquidity Risk Crucial for UAE Banks” [online], Available: http://www.khaleejtimes.com/darticlen.asp?section=business&xfile=data/business/2009/April/business_April979.xml [Accessed 21st November, 2010].
• Nazneen (2007) “How to measure and manage liquidity risk, interest rate risk and foreign exchange risk using GAP Analysis” Bangladesh Bank [online], Available: http://www.bangladesh-bank.org/mediaroom/circulars/brpd/gumeasurebrpd04.pdf [Accessed 28th November, 2010].
• National Credit Union Administration (2010) “Interagency Policy Statement on Funding and Liquidity Risk Management”, Federal Reserve [online], Available: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20100317.pdf [Accessed 30th November, 2010].
• Standard Chartered Annual Report (2008) “Managing risk responsibly”, Standard Chartered [online], Available: http://www.standardchartered.com/annual-report-08/en/financial_risk_review/risk_review.html#liquidity_risk [Accessed 30th November, 2010].