LIQUIDITY RISK

RAVIKUMAR.R, MOF
“Every Banker knows that if he has to prove that he is worthy of credit,
however good may be his arguments, in fact his credit is gone” – Walter
Baghehot
Liquidity Risk
 Liquidity risk is the risk to current or anticipated earnings or capital arising from an
inability to meet obligations when they come due. Liquidity risk includes the inability to
access funding sources or manage fluctuations in funding levels. Liquidity risk also results
from a bank’s failure to recognize or address changes in market conditions that affect its
ability to liquidate assets quickly and with minimal loss in value. (Updated 5/06/2013)

 Liquidity risk, like credit risk, is a recognizable risk associated with banking. The nature of
liquidity risk, however, has changed in recent years. Increased investment alternatives for
retail depositors, sophisticated off-balance-sheet products with complicated cash-flow
implications, and a general increase in the credit sensitivity of bank customers are all
examples of factors that complicate liquidity risk. (Updated 5/06/2013)
Definition
 Liquidity is generally defined as the ability of a financial firm to meet its debt obligations;
 The goal of liquidity risk management is to identify potential future funding problems.
 “Funding liquidity risk” is the risk that a firm will not be able to meet its current and
future cash flow and collateral needs, both expected and unexpected, without materially
affecting its daily operations or overall financial condition without incurring unacceptably
large losses
 or
 Management of the firm’s ability to meet its obligations as they come due, without
incurring significant losses.
 Market Liquidity Risk is the RISK of loss arising from an inability to sell or pledge ASSETS
at, or near, their carrying value when needed; a subcategory of LIQUIDITY RISK.
Law Dictionary: [Link]
 Contingency funding plan (CFP) is the firm’s policies and procedures for
responding to liquidity disruptions. A CFP should outline how the firm intends to
manage a range of stress environments, including clear lines of management
responsibility.
 Liquidity crises may be inherently hard to avoid
Types of Liquidity
 Central Bank Liquidity:
 The ability to supply the flow of the monetary base needed to the financial system; results from
managing the central bank’s balance sheet;
 Funding Liquidity:
 The ability to settle obligations in central bank money with immediacy;
 (IMF) The ability of a solvent institution to make agreed-upon payments in a timely fashion;
 (Basel) The ability to fund increases in assets and meet the obligations as they come due,
without incurring unacceptable losses;
 Margin / haircut funding risk; short term borrowing rollover risk; redemption risk;
 Market Liquidity:
 The ability to trade an asset at short notice at low cost and with small impact on its price
Interplay – Virtuous Circle

• To balance • Redistribution and • Efficient allocation

Market Liquidity
Central Bank Liquidity

Funding Liquidity
aggregate demand recycling of central of liquidity
and supply bank liquidity resources
• Works well only • Works well only • Depends on CBL
when ML and FL when there is and ML
function well adequate liquidity
in financial system
and without
hoarding
 Mismatch or
Structural Liquidity
Risk Risk in the
current
balance sheet
structure

Future events may Inability to sell

require assets at or near
significantly larger the fair value
amount of cash Contingency Market Liquidity
Liquidity Risk Risk
Indicators of Liquidity Concerns
 increases in funding costs or funding concentrations
 the growing size of a funding gap
 the drying up of sources of liquidity or reductions in tenors
 a significant decline in the reserve of unencumbered liquid assets
Role of Board of Directors
 reviewing and approving the bank's liquidity strategy and all critical policies and
practices at least annually
 ensuring that senior management translates this strategy into clear guidance and
operating standards
 ensuring that senior management and staff have the necessary expertise and that
the bank has adequate systems and processes to measure, monitor and control all
sources of liquidity risk
 reviewing regular reports on the bank's liquidity position
 being immediately informed of any new or emerging liquidity concerns and
ensuring that senior management addresses these concerns in a timely way
Role of Senior Management
 The role of senior management is to manage the bank's liquidity within its risk
tolerance.
 Senior management defines the bank's liquidity strategy under the direction of
the Board of Directors.
 This should be appropriate for the nature, scale and complexity of the bank's
activities and take into consideration its legal structures, the scope of its operations
and the various home and host regulatory requirements that it needs to comply
with.
Funding Diversification
Banks are expected to establish:
 funding limits by counterparty, instrument type, currency and geographic market
 a diversification of wholesale funding sources, whether secured or unsecured, to
ensure timely access to funds at reasonable costs and appropriate maturities
 a higher reserve of unencumbered liquid assets if they depend more on volatile
wholesale funding sources than on retail funding
 access to diverse sources of liquidity for each of the major currencies in which a
bank is active
 Implementing this strategy includes developing liquidity risk policies on the:
 composition and maturity of assets
 diversity and stability of funding sources
 management of liquidity in different currencies, across borders, and across business
lines and legal entities
 management of intraday liquidity
 liquidity and marketability of assets
 These policies should allow the bank to manage its liquidity needs under normal
conditions and under periods of liquidity stress, regardless of the type of stress
involved.
Implementing Liquidity Strategy
 Senior management should determine the structures, responsibilities and
controls that are needed to ensure that the liquidity strategy is implemented
effectively.
Aligning Incentives with Prudent Risk Taking

 senior management should fully "incorporate liquidity costs, benefits, and risks in
the internal pricing, performance measurement and new product approval
processes for all significant business activities".
 The expected holding period of assets and liabilities as well as their liquidity risk
characteristics to be considered.
 The main rationale is to ensure that line management incentives are aligned with
the bank's broader liquidity risk tolerance and strategy.
Risk Tolerance
 Limit determining variables: (other than regulatory caps)
 The bank’s risk appetite
 The bank’s level of capital
 The bank’s level of earnings
 The perceived likelihood of an unusual funding need
 The confidence in measures of current and projected liquidity
 The bank’s level of immediately available liquidity
 The ability to quickly and reliably convert stand-by liquidity sources into cash
 The relations ship between the potential risk and the potential reward
 The other, non-liquidity, risk exposures to which the bank is currently exposed.
 Credit Risk

Reputational Liquidity Market Risk

Risk
Risk

Interest Rate
Risk
Recent Developments
 Intraday Liquidity Risk management
 LCR or Liquidity Coverage Ratio
 NSF or Net Stable Funding Ratio
 Focus on Fund Transfer Pricing
Monitoring Liquidity
 Cash Flows
 Two dimensions – time and amount
 Type of cash flows
 Fixed
 Credit related – may be affected by credit events
 Indexed / contingent – depends on the market variables
 Behavioural – affected by the decision of the customers
 New business
 Liquidity Options
 Savings and current accounts
 Premature withdrawal of time deposits
 Availing the un-availed portion
 Liquidity Risk
 The event that in the future the bank receives smaller than expected amounts of cash flows to
meet the payment obligations
 The amount of economic losses due to the fact than on a given date the algebraic sum of
positive and negative cash flows and of existing cash available at that date, is different from some
desired / expected level
 The event that in the future the bank has to pay greater than expected cost above the risk-free
rate to receive funds from sources of liquidity that are available (FUNDING COST RISK).
 Cash Flow at Risk (CFaR)
 Cash Flow-at-Risk (CFaR) is a risk measure that conveys information on the shortfall in cash
flow, associated with a certain probability, a firm could experience over a certain time period.
 Liquidity Buffer: The available liquidity covering the additional need for liquidity
that may arise over a defined short period of time under stress conditions.
 Maturity mismatch
 Collateral Margining
 Off-balance sheet commitments
 Counterbalancing Capacity (CBC) – A set of strategies by which a bank can cope
with liquidity needs by assuming the maximum possible liquidity generation
capacity (LGC)
Behavioural Models
 Prepayment modelling;
 Sight Deposit and Non-maturing liability modelling
 Credit line modelling;
Table 17. Objectives of liquidity regimes
To ensure that an adequate
Adherence to sound or best practices risk management process is
in place (sound/best practices)
To ensure that a banks’ maturity mismatch is manageable (i.e. to
meet payment obligations at all times at a reasonable cost)

Viability of firms’ funding liquidity To ensure that a bank

survives to a fixed time
Explicit objectives horizon
To ensure that a bank has a
minimum level of liquidity
Survival to a fixed horizon in terms of quantitative requirements:
• Sufficient liquidity buffers;
• Sufficient highly liquid assets to cover unexpected
Survival to a fixed horizon withdrawal of deposits or short term liabilities,

Combinations of aims:
• To countermeasure against possible market failure
• Limiting excessive risk taking and adherence to best practices;
Underlying aims • Minimize systemic risk and adherence to best practices;
• supervisory assessment of the risks and management practices of the institution;
• protection of the interests of investors and depositors;
• promotion of the development and stability of the financial and capital markets;
• transparency and accountability of liquidity risk management;
• methods for its identification and indicators of liquidity crisis for banks
• etc.
Pricing Liquidity Risk
 The interest rate, the funding spread and the contingent liability components are
paid to the treasury department
 The credit spread is paid to the credit department
 Market and liquidity / behavioural options are paid to the ALM department
 Remuneration of economic capital is paid to the shareholders as dividend
 The commercial margin is assigned to the business unit selling the loans
 The non-financial margin is assigned to the operational / general services, IT
departments;
 Liquidity mismatch costs;
 Tranching approach
 Internal rate of return approach
 Contingency liquidity risk costs
 Cost of holding stand-by liquidity provided by liquid assets;
 Cost of loan commitments;
 Cost of market liquidity
 Leads to liquidity transfer pricing;
Risk Measurement - Quantitative
 Balance Sheet Liquidity Analysis
 Cash Capital position
 Maturity Mismatch Approach
 Ratios
Risk Assessment - Qualitative
 Are diversified funding sources established
 What is the current long term / short term rating of the bank and what is the
outlook?
 Is there a board approved liquidity policy in place with fixed standards on
responsibilities, methodologies, limit system and reporting?
 Has the bank implemented an IT infrastructure that allows for daily quantitative
assessment of liquidity risk?
 Stress testing is being carried out and the results reckoned?
 Whether a contingency plan exist that addresses responsibilities of each unit and
the measures to be taken?
 Has the bank established an internal transfer pricing system for liquidity risk?
Fund Transfer Pricing – FSA Regulation
 FTP is thus a regulatory requirement and an important tool in the management of
firms’ balance sheet structure, and in the measurement of risk-adjusted
profitability and liquidity and ALM risk. By attributing the cost, benefits and risks
of liquidity to business lines within a firm, the FTP process strongly influences the
volume and terms upon which business lines trade in the market and promotes
more resilient, sustainable business models.
Contingency Funding Plans
 Premise:
 Financial institutions can never avoid liquidity risk
 Financial institutions can do little to hedge liquidity risks
 No financial institution can afford to hold enough liquidity to survive a severe or
prolonged funding crisis.
Key requirements
 Triggers – to be described
 Specify a minimum number of triggers that define when the environment is no longer
normal
 Increase in the spread paid on uninsured deposits, borrowed funds or asset securitisations;
 Reductions in tenor lenders are willing to accept;
 Violation of liquidity limits;
 Decline in earnings;
 Increase in loan delinquency;
 Relative stock price movements;
 Significant asset growth or acquisitions;
 Legal, regulatory or tax changes that either increase risks or make risk management more
difficult
 A downgrading by a national rating agency
 To address each category of liquidity enhancement tactics;
 To fit with bank’s liquidity management and stress testing framework;
 Remedial actions
 Details of crisis management teams or committees;
 Reporting
 Communications;
 Use of or avoiding central bank borrowings;
 Review and update annually;
Bibliography
 BANK LIQUIDITY RISK MANAGEMENT AND SUPERVISION: WHICH LESSONS FROM RECENT MARKET TURMOIL?
 Gianfranco A. Vento and Pasquale La Ganga - Regent’s College, London and Università Telematica “Guglielmo Marconi”, Rome. E-mail: [Link]@[Link]; Banca d’Italia, Banking Supervision
Department.
 Measuring and Managing Liquidity Risk – Wiley Finance – Antonio Castagna / Francesco Fede
 Liquidity Risk – Measurement and Management – A practitioner’s guide to global best practices – Wiley Finance – edited by Leonard Matz and Peter
Neru