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

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 assetsEnables bank to avoid unprofitable sale of assets
Lowers the size of the default risk premiumLowers 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
AcquisitionsAcquisitions
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:
InternalInternal
Perception
of
Institution
in various
markets
•Local
•Regional
•National
•International
ExternalExternal
Geographic
Systemic
Instrument
Specific

Types of Risks
Funding RiskFunding 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 RiskTime 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 RiskCall 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
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 assetsRatio 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 LadderMaturity Ladder
Alternative ScenariosAlternative Scenarios
Measuring liquidity over the chosen time frameMeasuring liquidity over the chosen time frame
Assumptions used in determining cash flowsAssumptions 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 CrisisBank 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 CrisisGeneral 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 assetsAssumptions 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 liabilitiesAssumptions regarding liabilities
• Level of cash outflows on crystallization of contingent liabilities
Assumptions regarding Off balance sheet activitiesAssumptions regarding Off balance sheet activities
• Funds to support operations
• Net overhead expenses
Other AssumptionsOther 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

Contingency Planning
• 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

Do you have any questions or queries or some feedback to give?
Just mark an email to super.msahluwalia@yahoo.com

For more Super-Notes: Click Here
M S Ahluwalia, amongst other things, is a visual artist, blogger,
blog designer and of course an MBA and Banker from New
Delhi, India.
To know more about him you may visit his blog-site: Estudiante De La Vida

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

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