CAIIB Super Notes: Bank Financial Management: Module D: Balance Sheet Management: Liquidity Management

CAIIB – Super-Notes © M S Ahluwalia Sirf Business

Liquidity Management

Module D: Balance Sheet Management

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CAIIB – SUPER NOTES

Bank Financial Management: Liquidity Management





Contents

Coverage:

1. Introduction

2. Definition

3. Dimensions and Role of

Liquidity Risk Management

4. Measuring and managing

liquidity risk





INTRODUCTION

1.





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





DEFINITION

2.





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





DIMENSIONS AND ROLE OF LIQUIDITY RISK MANAGEMENT

3.





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





Functions of Liquidity Management

Demonstrates to the market place that bank is safe and has repayment capacity Demonstrates to the market place that bank is safe and has repayment capacity

Enables to meet its prior loan commitments – formal or informal Enables to meet its prior loan commitments – formal or informal

Enables bank to avoid unprofitable sale of assets Enables bank to avoid unprofitable sale of assets

Lowers the size of the default risk premium Lowers the size of the default risk premium





Adequacy determined by analysing

Historical Funding

requirements

Historical Funding

requirements

Current Liquidity Position

Current Liquidity Position

Anticipated future funding

needs

Anticipated future funding

needs

Sources of funds

Sources of funds

Options for reducing

funding needs

Options for reducing

funding needs

Present and anticipated

asset quality

Present and anticipated

asset quality

Present and future earnings

capacity

Present and future earnings

capacity

Present and planned capital

position

Present and planned capital

position





Factors affecting Bank liquidity

Decline in Earnings

Decline in Earnings

Increase in NPAs

Increase in NPAs

Deposit Concentrations

Deposit Concentrations

Downgrading by rating agencies

Downgrading by rating agencies

Expanded business

opportunities

Expanded business

opportunities Acquisitions Acquisitions

New tax initiatives New tax

initiatives





How to meet funding requirements?

Dispose of Liquid Assets

Dispose of Liquid Assets

Increase short term

borrowings

Increase short term

borrowings

Decrease holdings of less

liquid assets

Decrease holdings of less

liquid assets

Increase liabilities of a term nature

Increase liabilities of a term nature

Increase capital funds

Increase capital funds

Securitisation of Assets

Securitisation of Assets





Types of Liquidity Risks

• Based on source of origin:

Internal Internal

Perception of Institution in various markets

• Local

• Regional

• National

• International

External External

Geographic

Systemic

Instrument Specific





Types of Risks

Funding Risk Funding Risk

Need to replace net outflows due to unanticipated

withdrawals/non-renewal

Arises due to:

• Fraud Causing substantial loss

•Systemic risk

•Loss of Confidence

•Liabilities in Foreign Currencies

Time Risk Time Risk

Need to compensate for non-receipt of expected

inflows of funds

Arises due to:

•Severe deterioration in asset quality

•Standard assets turning into NPA

•Temporary Problem in recovery

•Time involved in managing liquidity

Call Risk Call Risk

Crystallization of contingent liability

Arises due to:

•Conversion of non-fund based limit to fund based limit

•Swaps and Options





MEASURING AND MANAGING LIQUIDITY RISK

4.





Elements of strong liquidity management

Good management information system Good management information system

Central Liquidity control

Central Liquidity control

Analysis of net funding

requirements under alternative scenarios

Analysis of net funding

requirements under alternative scenarios

Diversification of funding sources Diversification of funding sources

Contingency Planning






Steps necessary for managing liquidity risks

Developing a structure for

managing liquidity risk

Developing a structure for

managing liquidity risk

Setting tolerance level and limit for

liquidity risk

Setting tolerance level and limit for

liquidity risk

Measuring and Managing Liquidity

Risk

Measuring and Managing Liquidity

Risk





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





Strategy should

• Set out general approach to liquidity including quantitative and qualitative

targets

• Address bank’s 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





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






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 bank’s global liquidity in major foreign

currencies to the management of foreign office in the country issuing the

respective currency






2. Liquidity strategy in each currency:

Bank’s 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





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





Measuring and Managing Liquidity Risk

Approaches:

1. Stock Approach

2. Flow Approach





Stock Approach

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

exposures on a particular date

•Core Deposit/Total Asset

•More the ratio better it is because core deposits are stable sources of liquidity.

Ratio of Core Deposit to total Assets: Ratio of Core Deposit to total Assets:

•Net Loans/Total Deposit

•It reflects the ratio of loans to Public Deposits or core deposits. Lower the ratio is the better.

Net Loans to Total deposits Ratio: Net Loans to Total deposits Ratio:

•Time Deposits/Total Deposits

•Higher the Ratio better

Ratio of Time Deposits to Total Deposits: Ratio of Time Deposits to Total Deposits:

•Volatile Liabilities/Total Assets

•Lower the Ratio the Better

Ratio of Volatile liabilities to total assets Ratio of Volatile liabilities to total assets





Stock Approach

• Short Term Liabilities/Liquid Assets:

• Lower the Ratio the better

Ratio of Short Term Liabilities to Liquid Assets: Ratio of Short Term Liabilities to Liquid Assets:

• Higher the Ratio the better

Ratio of Liquid Assets to Total Assets: Ratio of Liquid Assets to Total Assets:

• A lower ratio is desirable

Ratio of Short Term Liabilities/Total Assets: Ratio of Short Term Liabilities/Total Assets:

• Higher the ratio the better

Ratio of Prime Asset to Total Asset: Ratio of Prime Asset to Total Asset:

• Lower the ratio better

Ratio of Marketable liability to total asset: Ratio of Marketable liability to total asset:

Indian Banks do not follow this approach





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





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

• Bank’s 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





Aspects

Maturity Ladder Maturity Ladder

Alternative Scenarios Alternative Scenarios

Measuring liquidity over the chosen time frame Measuring liquidity over the chosen time frame

Assumptions used in determining cash flows Assumptions used in determining cash flows





The Maturity Ladder

• To compare a bank’s 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





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





Alternative Scenarios

General Market Conditions

General Market Conditions

• Benchmark for the ‘normal business’ behavior of the balance sheet

• Useful in managing a bank’s use of deposits and other debt markets

Bank Specific Crisis Bank Specific Crisis

• A type of ‘worst-case’ benchmark

• Many of the bank’s 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 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





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 bank’s liquidity and to check how consistent

and realistic the assumptions are for the individual bank





Assumptions used in determining cash flows

• 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 assets Assumptions regarding assets

• Level of rollovers of deposits and other liabilities

• Effective maturity of deposits with non-contractual maturities

• Growth in new deposit accounts

Assumptions regarding liabilities Assumptions regarding liabilities

• Level of cash outflows on crystallization of contingent liabilities

Assumptions regarding Off balance sheet activities Assumptions regarding Off balance sheet activities

• Funds to support operations

• Net overhead expenses

Other Assumptions Other Assumptions





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






• 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





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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Documents

CAIIB Super Notes: Bank Financial Management: Module D: Balance Sheet Management: Liquidity Management