CHAPTER - IV

CHAPTER - IV

LIQUIDITY RISK MANAGEMENT

- CONCEPT
> SOURCES OF LIQUIDITY
> NEED FOR LIQUIDITY
> LIQUIDITY RISK
> RECENT EXPERIENCES

■ LIQUIDITY RISK MANAGEMENT

> OBJECTIVES
> STRATEGIES

■ TECHNIQUES FOR LIQUIDITY MONITORING &

PLANNING
> COMPARITIVE ANALYSIS OF LIABILITY
> MATURITY MATCHING OF ASSET AND LIABILITY
> LIQUIDITY FORECAST AND PLANNING

■ CONCLUSION
■ REFERENCES
LIQUIDITY RISK MANAGEMENT

Concept:

Liquidity risk is defined as the potential inability of the bank to generate cash to cope
with the withdrawal of the deposits or increase in the assets. In case of a commercial
bank liquidity connotes its ability to honour or meet its commitments as and when they
arise. The main feature of liquidity is the ability of a given asset to get converted into
cash without involving any capital loss. Thus depending upon the nature of the asset the
degree of liquidity may rise or fall, which in turn would determine its ability to borrow in
the money market or from other sources if it becomes unavoidable.

Sources of Liquidity:
A commercial bank derives liquidity from its own assets & liabilities. Normally
banks derive liquidity from Share capital, Long term loans, Domestic and non - resident
deposits, Deposits with Central Bank, Inter bank borrowings and short term money
market instruments. On the assets side items such as Cash, Treasury Bills, Trade Bills,
Investment in Govt. Securities, Loans & Advances, are main contributors to the liquidity
pool. A commercial bank has to ensure a reasonable degree of correspondence between
the sources of liquidity and the demand for it. This signifies that the maturity periods of
the liabilities and assets should broadly coincide. Thus unstable components of liabilities
that may result in the outflow of the funds have to be backed by such assets that a
commercial bank could sell, discount or pledge at short notice and without loss to meet
the outflow. This is the process of matching the maturities of liabilities and assets which
forms the very basis of the ALM technique.From the liquidity point of view not only the
equality of the assets & liabilities but also the quality of liquidity sources is important.

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Need For Liquidity:
A commercial bank may experience net outflow of funds either due to withdrawal
or due to non - renewal of the deposits by the customers, which leads to severe liquidity
crunch that needs to be covered up. Similarly shortage of liquid funds can also arise from
the failure of expected inflows due to non-payment or due to delayed payment of loans
and advances and other funds. Sometimes certain contingent liabilities also result in
unexpected cash outflows. Thus, it is necessary for a commercial bank to have sufficient
liquid funds so as to meet any requirements.

Liquidity Risk:
A commercial bank as an institution has to maintain public trust/ faith/confidence
at all times. The erosion of public faith can lead to excess withdrawals leading to severe
liquidity crunch. The recent turmoil in some of the banks in Gujarat has suggested that a
major source of liquidity risk was mismatch of maturities of assets & liabilities. The lack
of balance between maturity periods of assets and liabilities may be the result of
excessive short borrowing and excessive long lending. In such a situation the alternatives
available to a bank can further aggravate the situation by giving rise to other risks. For
example if a bank is facing liquidity crunch due to short term borrowing and long term
lending the only alternative left with the bank is to borrow at the prevailing rate of
interest and offload its short term liabilities. Thus, the bank will run the risk of additional
cost, if the market rates turn high or the bank may have to sell its assets on a lower
market rate and there may be a capital loss, adversely affecting the value of the assets and
impinging on profits. Again liquidity risk may arise if assets and the liabilities of a bank
are concentrated in a few segments of the market i.e. if the bank does not have diversified
deposit base or asset base. Even if the maturities of assets and liabilities are reasonably
matched liquidity risk may still arise due to variety of reasons viz. interest rate changes in
respect of assets & liabilities, decline in the value of the assets, foreign exchange losses
and last but not the least, Contingent claims on the bank giving rise to unexpected cash
outflows.

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Recent Experiences:

The recent turmoil particularly in the co-operative banking sector in Gujarat and
elsewhere aptly explains that it is due to maturity mismatches in the assets and liabilities
giving rise to liquidity risk & resultant loss of public confidence in these banks. Few
more instances of liquidity problems faced by commercial banks worth mentioning here
are of New bank of India (due to substantial losses), Bank of Karad (in the wake of
securities scam) and more recently that of Global Trust Bank (due to high level of NPAs).
All these banks were merged into strong banks due to timely RBI intervention. In general
it is also observed that banks fund their term loans with short term liabilities/deposits this
explains the rationale of banks being captive participant in money market operations
mainly as borrower. The market driven rate of interest in the money market are often
higher than cost of demand deposit mobilisations.

To substantiate further it is observed that cash credit arrangement forms a sizable

portion (2/3rd of all forms of advances) with the Public Sector Banks (PSBs), Technically,
this arrangement does not have any maturity period but the liabilities backing this
arrangement have a maturity period. Apart from the mismatch the arrangement
accentuates the liquidity problem because of the wide fluctuations in these accounts,
particularly during the full utilization of the cash credit limits at a time when the funds
position of the bank is difficult.
Second most important reason of asset liability mismatch in the Indian banking scenario
has been identified as large investments in government securities. Investments in
government securities range from a period of 5 - 15 years. Whereas funds deployed in
these investments have fixed maturities of 3 - 5 years. In absence of secondary market
the sale of these securities (esp. at the time of liquidity crunch) becomes very difficult
and often banks have to incur heavy capital losses1.

Hence banks in India should develop their internal mechanisms for better liquidity
management in line with prudent bank management standards as laid down by Basel
Committee. We submit that banks should look for:

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 a) Widely diversified sources of liquidity. Banks should ensure in terms
of quality and appropriate mix of liquidity sources with product mix
& processes.
b) Thoroughly reviewing internal inspection, audit and data mechanising
processes and lastly,
c) A mechanism to forecast liquidity needs and also the sources of
liquidity. Review the trends in actual at least once in three months and
make suitable adjustments in assets Sc liabilities to remain liquid at all
times.

Liquidity Risk Management:

Measurement and management of liquidity needs are essential for sustained &
profitable operation of banking business. Proper liquidity management can reduce the
probability of development of an adverse situation by ensuring banks ability to meet
its liability as they become due. The importance of liquidity transcends individual
bank, as liquidity shortfall in one bank have repercussions on the other banks & other
constituents of overall financial system. Bank managements should therefore, measure
not only the liquid position on an on going basis but also examine how liquidity
requirements are likely to evolve under different assumptions. Hence, as mentioned
earlier, liquidity has to be tracked through maturity or cash flow mismatches. For
measuring and managing net fund requirements, the use of maturity ladder and
calculation of cumulative surplus or deficit of funds at selected maturity dates be adopted
as a standard tool. The Annexures I, & III given at the end of Chapter II, show the
standard format provided by the RBI for “Maturity Profile”& “Statement of Short Term
Dynamic Liquidity” respectively under the ALM guidelines. Taking this into
consideration the ALM Policy of any commercial bank in India is based on two fold
objectives of ensuring profitability as well as ensuring liquidity.

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Objectives:

Objectives of liquidity risk management at the bank level include:

a) Assessment of capability of a commercial bank to obtain stable funding source from
concerned parties.
b) Formulation, dissemination and controlling policies, procedures & parameters which
have been established by ALCO for managing banks liquidity position as a whole and
ensuring that all primary outlets/branches are conforming to and are operating within
the prescribed guidelines.
c) Formulating & providing internal management reports with necessary information for
making liquidity decision and monitoring the results of these decisions.
d) Evaluating the management of assets & liabilities and Off Balance Sheet Positions
(OBSPs)2 and finally,

e) Developing remedial actions in cases where policies, procedures or internal controls

are found to be deficient for proper liquidity management.

Strategies:
The liquidity risk management covers specific strategies for the asset management
& liability management or a combination of both,
liability management strategies include:
> Evolving framework whereby short - term borrowings or short - term deposit
liabilities can be increased.
> Promoting proposals that bring about diversification in the sources of funds of the
commercial bank.
> Increasing the capital fund base of the bank.
Asset Management Strategies include:
> Improvements in the asset quality by adopting different techniques like
securitisation.
> Formulation of a specific time frame for the sale of surplus liquid assets.
> Developing a suitable strategy whereby holding of less liquid assets can be
reduced.

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However the, implementation of any ALM strategy by banks should be taken on the
following considerations:
• Profit spread: That sometimes highly liquid assets offer thinner profit spreads
• Relative difficulty in liquidation: That certain assets considered to by highly
liquid are actually very difficult to liquidate,
• Opportunity cost That maintenance of a strong liquidity position may be at the
opportunity cost of generating higher earnings.
• Seasonal, cyclical and cost factors: That these factors lead aggregate outstanding
loans and deposits to move in opposite directions resulting in demand of funds
exceeding its supply & vice- versa.

In sum, the banks should evolve a proper framework for an effective contingency
plan which can identify minimum and maximum liquidity needs and can suggest
alternative courses of action to meet those needs within short span of time. Factors that
may initiate contingency planning include;
> Increase in the level of Non - Performing Assets (NPAs)
> Tax initiatives of the govt.
> Diversification & expansion of business opportunities
> Concentration of deposits
> Decline in business or earnings
> Unfavorable rating or down gradation by a rating agency.

Techniques For Liquidity Monitoring & Planning:

As said earlier it is important for the bank for various reasons to remain in liquid
to meet firstly the operational transactions i.e. the customers demand for withdrawals.
Secondly the retail banking i.e. to accommodate any increase in credit demands and
thirdly, to make investments in securities for profit maximisation purposes etc.
Three different approaches3 viz. comparative analysis of liability, comparative analysis of

asset-liability & finally liquidity forecasts and planning approaches are presented here,
through which bank can monitor its liquidity management. For theoretical presentations

57
we explain the essence of liquidity monitoring using chart form as well as suggestive
illustrations.

Approach -1
Comparative Analysis: For overall as well as component mix :
Firstly to study the current liquidity positions bank may analyse the overall actual
positions with the performance budget, preferably on a quarterly basis. The significant
differences between actual & budgeted positions be reviewed and explained in detail.
Also the current period information can be compared with previous period to identify,
monitor & manage the unfavourable trends.
Secondly, based on type & sources of liability, mix be analysed to examine the reliance
on the funding source as well as the cost of the source. This concept is presented in
Chart 4.1 at the end of the chapter on page no.62. Monitoring of these pressure points
helps in exploring alternate means to deal with them in advance. Thus, monitoring helps
in raising liability mix in a reasonable and cost - effective manner.

Approach - II
Maturity Matching of Asset & Liability:
in the earlier chapter III we have presented table 3.2 on maturity matching of Assets &
Liabilities of a sample bank. The analysis helps us in determining the future funding
requirements by comparing the amount of assets & liabilities maturing over a specific
period. Chart No. 4,2 presented on Page No. 63 provides illustrative liquidity gap
calculations of a sample bank.
It is evident from the chart that the bank should avoid these liquidity gaps. Negative
mismatches mean that the is poorly positioned to meet unexpected funding position needs
without incurring high cost. Further, the cumulative liquidity gap position spot the
growing mismatches between assets & liabilities over time.

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Approach - III
Liquidity Forecasts & Planning:
Under this approach the probability of occurrence of a future event can be identified. This
forecast then also project that how these events might affect the funding needs of a bank
and finally, helps in meeting these liquidity needs. Let us take an illustration to explain
the practical aspects of this approach.
A sample bank forecast could show planned asset growth and ways to meet the funding
the same. Alternately, bank might attempt to identify future fund inflows and set out
ways to redeploy the future inflows to maximise profits & also provide appropriate
cushion to liquidity needs too. However, the period of forecast is left to the bank. For a
bank in good condition a monthly or quarterly forecast may be adequate whereas bank in
poor condition or experiencing liquidity problems, weekly or daily forecasts may be
needed. Further, liquidity forecast be compared with actual out-standings and the reasons
for forecast variations or in-accuracies above ± 10 % range may be outlined. The
components of source of cash funds include opening balance (both cash & bank
balances), High value deposits, Time deposits, jumbo certificate of deposits, Borrowings
from RBI, Maturing investments, Cash in Hows by the way of loan recovery,
securitisation, maturing investments, assets sales etc. Similarly uses of cash fund include
pay for maturing deposits of all types, balances with RBI, asset purchase, credit
accommodations etc. Here it is pertinent to study the nature of deposits as sources of cash
funds and maturing of deposits as uses of liquidity for liquidity planning. All deposits
with bank can be classified under 3 categories viz.
> Deposits that are stable in nature
> Deposits that are vulnerable in nature
> Deposits that are volatile in nature
The deposits that have least probability of withdrawals during the planning period are
known as stable funds, eg. Funds available in the Term Deposits.
Deposits that are likely to be withdrawn during the planning period are considered as
vulnerable funds, eg. Funds in the saving bank accounts.

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volatile funds basically comprise of the deposits that are most likely to be withdrawn
during the period for which the liquidity estimate is to be made. They basically
comprise of short term deposits mobilised from corporate & High Net Worth
Individuals (HNWI - segment).Another dimension of the volatile funds is the float
funds, i.e. the funds that are generally in transit like Demand Drafts, Pay
Orders/Banker’s Cheques etc. which may be presented for payment any time.

It is important in liquidity monitoring to examine closely any increase in shares of

high cosl resources & its appropriate deployments. Similarly any downward trends in
cash flows imply a declining liquidity position & reasons for the same be identified.
In conclusion, a bank management constantly need to monitor and manage liquidity
positions which may arise due to various factors. This requires developing suitable
policies to address comprehensively the liquidity needs, monitoring liquidity
positions & planning the future funding needs.

Conclusion:

Under the present competitive & financial environment liquidity position of a

commercial bank change at a very fast pace and it is the responsibility of the lop
management to ensure that the bank has sufficient resources to deal with these
changes. This requires establishment of a proper policy framework that can address to
the following:
i) Basic liquidity need
ii) Monitoring the liquidity position
iii) Planning for the future funding need
This will not only help in reducing stress on bank’s balance sheet but will also help in
creating better & stable portfolios.

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 References:

1) T.K. Velayudham (1995): Liquidity Risks in Banks -Paper presented in 18th Bank
Economist’s Conference, Chennai 1995 : Published by Indian Overseas bank
2)Tarjani Vakil (1996): India: Fast Forward - Exim Bank of India
3) Vijayakumar V.P (April 2001): Asset Liability Management System for
Banks: unpublished Project report - M.S. Patel Institute of Management Studies, MSU
Baroda
4) www.contingencyanaiysis.com

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 C hart h-i

TECHNIQUES FOR LIQUIDITY MONITORING: HIGH RATIO MEANS:

A) FEW INTERNAL RESOURCES REMAIN
COMPARATIVE ANALYSIS B) LIQUIDITY SACRIFICED FOR EARNINGS

HISTORICAL PERIOD
CURRENT PERIOD

QUARTER BUDGET ACTUAL DIFFERENCE TYPES SOURCES PREVIOUS CURRENT

OF LIQUIDITY // YEAR YEAR
ENDED

-
CREDITDEPOSIT +
RATIO

CM
HIGHVALUE DEPOSITS
TOTALDEPOSITS

cn
Q
0-4 S
£K
■fcLo

g^

s
h 005 So
Q
w rl gfg

04
a
q

Q
a
00

WH
Q o
00 2

82
THE SIGNIFICANT DIFFERENCE HIGHER RATIO MEANS REDUCED
BETWEEN BUDGET AND ACTUAL EARNINGS DUE TO HIGHER COST OF
BE EXPLAINED THESE FUNDS

HIGH VALUE MEANS THAT FEW

SECURITIES ARE AVAILABLE FOR SALE
CURRENT PERIOD INFORMATION BE TO RAISE LIQUIDITY/CASH
COMPARED WITH PREVIOUS PERIOD TO
IDENTIFY, MONITOR AND MANAGE LIQUIDITY
POSITION _____________________________

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 CHART No. 4.2

ILLUSTRATIVE LIQUIDITY GAP CALCULATIONS AT A SAMPLE BANK

Techniques of Liquidity Management - Maturity Matching of Asset Liability

(Fig.in Rs. Crores)

Particulars Maturity Period (in Months)
More
One 2 to 3 4 to 6 7 to 12 13 to 24 25 to 36 than 36
Maturity Matching Month Months Months Months Months months Months
Assets 10 5 8 ' ' 4 45 20 8
Liabilities 15 10 5 10 30 10 20
Liquidity (5) (5) 3 (6) 15 10 (12)
Cumulative Liquidity
Gap (5) (10) (7) (13) 2 12 0

Note: Based on Table 3.2

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