Liquidity Risk Management

Liquidity risk management refers to the potential ability

of a financial institution
to generate fresh liabilities either to cope with any decline in liabilities or
increase in assets. Implicitly, therefore, liquidity risk management involves ma
naging the two conflicting objectives
for any financial institution. One:
a liquidity crisis in the bank
could have serious ramifications in terms of its reputation, hence, most well-ru
n banks do
all possible to eliminate liquidity risk eliminate potential liquidity risks,
financial institutions will be required to invest
in highly liquid assets
which are short term in nature or in risk-free instruments, such as government b
onds, in both of which the yields would be very low.
In other words, managing liquidity risk involves potential reduction in interest
income
and therefore, an adverse impact on the overall profits of the bank. We will now
look at some techniques used by financial institutions
to manage liquidity risk. The most fundamental one is the fundamental approach.
This approach involves investing
in assets that can be turned into cash easily. Example: investment in treasury b
ills
and government securities
and/or
complying with regulatory measures, such as
maintaining cash reserves, statutory liquidity reserves, etc. On the liability
side of the balance sheet, the focus should be on source of funds,
for example, source funds that are likely to remain with the bank for an extende
d period
of time rather than funds that could be withdrawn at short notice.
Furthermore, banks should carefully analyze its cash inflows and cash outflows,
and based on that gap,
source funds ahead of need. Do remember,
financial systems in most countries
would have a judicious mix of retail banks
that are implicitly deposit rich,
hence liability led
vis-a-vis wholesale banks or corporate banks that are asset led and always hungr
y
for funds. The second approach to manage liquidity risk is the technical approac
h.
The technical approach essentially focuses on liquidity in the short term.
This is achieved through two methods.
The first one is called the working funds approach
and the second is called the cash flow
approach.
Let's look at both of these approaches in some detail.
First, working funds approach.
This involves segregating the source of funds, that means, the liabilities that
are coming up for maturity in the near term
into three categories:
volatile funds, vulnerable funds, stable funds.
Volatile funds includes funds that are sure to be withdrawn when they come up fo
r maturity. For example,
based on past data, the bank has determined that out of a deposit base of 10 mil
lion currency units,
3 million currency units of certificate of deposits and fixed deposits

will be withdrawn when they mature.

That leaves 7 million CCU out of the 10 million CCU. Vulnerable funds
funds includes funds that are likely to be withdrawn on maturity.
In the above example, let's say, 4 million CCU of the remaining 7 million CCU ar
e vulnerable.
Assuming, based on past data, 50% probability of withdrawal,
the cash outflow for the bank would be a further 2 million CCU, that means, 50%
the 4 million CCU of
vulnerable funds. Stable funds represent those funds with the least probability
of withdrawal when they come up for maturity.
In the example that we saw, the 3 million CCU of the 10 million CCU that is rema
ining
can be classified as stable funds,
and therefore, most likely to be
rolled over when they mature. Based on the above arithmetic, the bank's effectiv
e cash outflow will be
5 million CCU in the immediate future
comprising of 3 million of volatile funds which are sure to go away and 2 millio
n CCU which is 50% of the 4 million vulnerable funds.
Good liquidity risk management by the bank requires that they proactively source
sufficient liquidity
to meet the expected cash outflow of
5 million in the near term. Now let's look at
the cash flow approach to manage liquidity risk. This is also referred to as the
maturity ladder model proposed by the Bank of International Settlements.
In fact, several central banks around the world have mandated this approach
for liquidity risk management to all the institutions
that they have an oversight responsibility.
This approach involves laying down the planning horizon, or the buckets, as they
are normally referred to, and estimating the cash inflows
such as loan repayments, inflow of fresh deposits, etc., as well as cash outflow
s
by way of loan disbursement, closure of deposits, etc., in each of those plannin
g horizon or buckets.
A bank forecasts these cash inflows and cash outflows for each of these buckets
and determines the liquidity needs for each planning horizon with specific focus o
n
the short term.
Let's look at a spreadsheet example to understand this better. What we have here
is
four planning horizons: one day, one week, one month, six months.
Along the Y axis, we have various items of cash inflow,
such as maturing assets, that is, loans and bonds that are maturing in that comi
ng planning horizon;
assets that are available, they are not maturing but they are available for sale
if required,
therefore, they could be used for liquidity management;
then the potential for additional deposits;
open borrowing limits with other institutions; and portfolio that is ready to be
securitized.
There could be other lines of cash inflow, but in the example, I have taken only
these. If we look at the cash outflows for this particular institution,
maturing deposits unlikely to be renewed, which means that there will be a cash
outflow;
loans that have been committed, which are likely to be drawn down by the borrowe
rs; fresh investments in bonds and securities that the
institution would like to make; and setting aside some cash for unforeseen event
s.
So, these are the cash outflow items that we have considered.
There could be other items of cash outflow just like there could be other items of

cash
inflow. Now, if you look at, for example, the planning horizon for the
next 24 hours, what it shows you is the CCU in millions
that are likely to inflow against each of these line items,
and the total adds up to a 163 million CCU, and the cash outflows indicate again
st each of those line items
what is the cash outflow. For example, 47 million CCU of maturing deposits
that are unlikely to be renewed and therefore, the cash will go out of the bank'
s system and so on and so
forth. Now, this adds up to a 155. The net cash flow
is positive, which means, 163 cash inflow
minus 155 cash outflow, which gives you a total of 8 million
CCU. So in other words, as of close of business tomorrow or the next working day
,
this institution is likely to be in the money by 8 million CCU. If you look at
the next time horizon, which is one week ahead, you have total cash inflows of 1
07,
total cash outflows of 120,
so the institution is out of the money by 13 million that's why the negative
sign, which is arrived at as the difference between 120, which is the cash outfl
ow
and 107, which is a cash inflow. Now, on a cumulative basis, minus 13
plus 8 gives you a figure of minus 5. Now, what this denotes is, ceteris paribus
(everything remaining constant), this institution would expect that one week fro
m now,
it would be out of the money by 5 million CCU, and if you take this forward to o
ne month, the cash inflows are
76, the cash outflows are 99, the institution is out of the money by 23 that's why
the minus 23.
Cumulatively therefore, minus 5, which is carried over from the previous plannin
g horizon up to one month, turns out to be minus 28. Now, this
not a very happy situation for the bank, but it can still cope with it because i
n the long term,
its cash inflows amount to a 131, whereas its cash outflows amounts to only 79.
So, if we were to look at a six-month time horizon, this institution is in a pre
tty happy state
because it is 24 million CCUs in the money.
So, what it needs to manage very carefully in terms of its liquidity is this min
us
and this minus 28. It does not have a liquidity problem on an overnight basis.
It does not have a problem
if you look at a planning horizon that is six months ahead. Hope that spreadshee
t example helped you understand how
the maturity ladder model proposed by the Bank of International Settlements
is used by financial institutions
to manage liquidity risk. Asset securitization is another method used by several
financial institutions to manage liquidity.
This involves taking future cash flows, such as repayment of long-term loans, mo
rtgage loans, etc., and
repackaging these cash flows into negotiable securities, issuing them to investo
rs,
and realizing those future cash flows immediately
on a discounted
basis. We will discuss asset securitization in much greater detail
in a later session in this course.