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Liquidity Risk

Solvency and Liquidity are considered the most important factors for sustainable growth and stability in Banking and FIs. Adequate solvency ensures absorption of expected or unexpected losses whereas Liquidity is the bank’s capacity to fund increase in assets and meet both expected and unexpected cash and collateral obligations at reasonable cost and without incurring unacceptable losses. Similarly, In case of non-financial companies, liquidity refers to the ability of a company to make cash payments as they become due. 

Bank’s keep the liquidity in form of cash, balance with other banks, excess CRR & SLR, short term investments in highly tradable securities to meet the requirement of funds as mentioned above. In absence of adequate liquidity there are cases when financial institutions were solvent but failed because of liquidity problems. 

Banks are required to maintain optimum level of liquidity to ensure that it is not losing it’s reputation and entering into another financial crisis due to it’s shortage and at the same time excess liquidity shouldn’t  drain the profitability of the banks. Therefore, Liquidity Risk Management is an important factor for FIs/Banks for their survival.

Liquidity Risk Management

Liquidity Risk arises when banks are not having sufficient funds to meet its deposit/borrowing obligations or not in position to grow their assets. It originates from the mismatches in the maturity pattern of assets and liabilities. 

Liquidity risk management helps ensure a bank’s ability to meet its obligations as they fall due and reduces the probability of an adverse situation developing. This assumes significance on account of the fact that a liquidity crisis, even at a single institution, can have systemic implications.

When Liquidity Risk occurs

Liquidity can occur due to any or more following reasons : 

• Liquidity Funding Risk –the risk of inability to efficiently meet the expected and unexpected current and future cash flows and collateral needs without affecting daily operations or financial condition.
• Market Liquidity Risk –the risk of inability to easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption.
• Time Risk – need to compensate for non-receipt of expected inflows of funds i.e. performing assets turning into non-performing assets; 
• Call Risk – due to crystallisation of contingent liabilities and unable to undertake

Objective- Liquidity Risk Management

The primary objectives are as under:

•  To ensure optimal liquidity position.
• To avoid concentration of funding that leads to potential liquidity problems.
• To put in place contingency planning for liquidity
• Reduces future cost of funding 
•  Liquidity shortage means adverse impact on bank reputation
•  Avoids needless fire-sale of assets and loss of interest income and future capital gains. 

In order to achieve the above objectives, banks address Liability side as well as Asset side liquidity management.

Liability-Side Liquidity Risk

• Focus on the volume of stable, long-term, core deposits and net deposit drains (deposit outflows less new deposit and other inflows each day).
• Need to predict the distribution of net deposit drains.
  • Behavioural analysis of NMDs.
  • Behavioural analysis of premature withdrawal, especially for high-value deposits.
  • Analysis of renewal patterns of maturing term deposits 

 Asset-side Liquidity Risk

• This risk arises from the committed line of credits like Cash Credit limits where in case of crises demand of funds increases.
• Cash flow uncertainness from risky assets
• Fund requirements to fund lucrative loan proposals or investments etc,,

Measurement of liquidity Risk

Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches.

Stock Approach

The key ratios, adopted across the banking system are Loans to Total Assets, Loans to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans, etc. While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional

Flow Approach

As recommended by regulators, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is considered  as a standard tool. In India, the format prescribed by RBI in this regard under ALM System is adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on projected future behaviour of assets, liabilities and off-balance sheet items.

These time buckets consist of, 1 day, 2-7 days. 8-14 days,15-30 days, 1-3 m, 3-6 m, 6-12m, 1-3yrs, 3-5yrs., > 5ys .

First four bucket’s tolerance limits are decided by RBI i.e. 5 % each and cumulative in the first four buckets is 20%. In the rest of the buckets , banks are free to decide the tolerance level.

Liquidity Standards 

As per Basel norms III, short term ( LCR) and long term (NSFR) liquidity management measures are introduced. The Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR) are significant components of the Basel III reforms

Liquidity Coverage Ratio (LCR) aims to ensure that a bank has an adequate stock of unencumbered HQLA that consists of cash or assets that can be converted into cash at little or no loss of value in private markets, to meet its liquidity needs for a 30 calendar day liquidity stress scenario.

The NSFR is defined as the amount of available stable funding relative to the amount of required stable funding. “Available stable funding” (ASF) is defined as the portion of capital and liabilities expected to be reliable over the time horizon considered by the NSFR, which extends to one year. The amount of stable funding required ("Required stable funding") (RSF) of a specific institution is a function of the liquidity characteristics and residual maturities of the various assets held by that institution as well as those of its off-balance sheet (OBS) exposures

Interest Rate Management

Due to ever changing market conditions in the financial sector, it is very difficult to estimate the direction and magnitude of Interest rate in future. If interest rate can be forecasted with a great deal of accuracy, Interest rate risk is mitigated to a very large extent. Predicting future interest rates essentially involves predicting the shape of the future yield curve. 

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition.

Sources of Interest Rate Risk

Repricing Risk::The primary and most often discussed form of  interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS)  positions.  For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase. These declines arise because the cash flows on the loan are fixed over its lifetime, while the interest paid on the funding is variable, and increases after the short-term deposit matures.

Yield Curve Risk: Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank's income or underlying economic value. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve.

Basis Risk: Another important source of interest rate risk (commonly referred to as basis risk) arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies. 

Optionality: An important source of interest rate risk arises from the options embedded in many bank assets, liabilities and OBS portfolios. An option provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the cash flow of an instrument or financial contract. 

Effects of Interest Rate Risk

Changes in interest rates can have adverse effects both on a bank's earnings and its economic value. This has given rise to two separate, but complementary, perspectives for assessing a bank's interest rate risk exposure.

Earnings perspective

It involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense.

Economic value perspective

It involves analyzing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off balance sheet items. It focuses on the risk to net worth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps.

Measurement of Interest rate Risk

There are two approaches followed by banks to measure IRR:-

1. Traditional Gap Approach ( TGA) : It is used to measure impact of change in interest rate on earnings of the bank i.e. impact on NII.
   
2. Duration Gap Approach ( DGA): It is used to measure the impact of change in interest rate on Market Value of Equity ( MVE).

Details of calculation and regulatory prudential limits shall be discussed in the next level in detail.

Written by Mr Rajesh Mahajan, former General Manager (Risk Management), Bank of Baroda. The article is based upon the lecture delivered by Mr Rajesh Mahajan in Banking Quest' online training "Program on Risk Management in Banks and NBFCs".