Unit 4

Liquidity Risk Management

Liquidity risk arises when a bank or financial institution cannot meet its financial obligations
as they fall due, either due to insufficient liquid assets or inability to raise funds in the
market. Effective liquidity risk management ensures a bank remains solvent during periods of
stress.

1. Measurement of Liquidity Risk

Measuring liquidity risk involves assessing the institution's ability to meet its short-term
obligations using various tools and metrics.

c. Liquidity Gap Analysis

 Identifies mismatches between the maturities of assets and liabilities.

 Breaks down assets and liabilities into time buckets (e.g., 1-30 days, 31-90 days).
 Gaps in these time buckets highlight liquidity risk.

d. Stress Testing and Scenario Analysis

 Simulates adverse conditions (e.g., market downturns, sudden deposit withdrawals) to

assess the institution's liquidity resilience.

e. Cash Flow Projections

 Tracks and projects cash inflows and outflows over time.

 Helps in identifying potential periods of cash shortages.
f. Loan-to-Deposit Ratio (LDR)

 Measures the proportion of customer deposits used for lending.

 Formula: LDR=

2. Measures of Liquidity Exposure

Liquidity exposure refers to the extent to which an institution is vulnerable to liquidity risk.
The following metrics and strategies help in evaluating and managing this exposure:

a. Asset Liquidity

 Measures the ease with which assets can be converted to cash without significant loss
in value.
 High-Quality Liquid Assets (HQLA), such as government securities, are considered
most liquid.

b. Funding Liquidity

 Assesses the institution's ability to raise funds in the market (e.g., issuing bonds or
obtaining loans).

c. Funding Gap

 Reflects the mismatch between liquid assets and short-term liabilities.

d. Market Liquidity Risk

 Measures the risk that the institution may not be able to sell assets quickly due to a
lack of market depth or adverse market conditions.

e. Concentration Risk

 High reliance on a small number of funding sources increases liquidity risk.

f. Contingent Liquidity Risk

 Arises from off-balance sheet items, such as unused credit lines, that may lead to
sudden liquidity demands.
3. Causes of Liquidity Risk

Liquidity risk can originate from both the asset side and the liability side of the balance
sheet.

a. Asset-Side Liquidity Risk

Occurs when assets cannot be liquidated in time or without a significant loss in value.

1. Illiquid Assets
o Holding a large proportion of illiquid assets, such as long-term loans or real
estate, reduces liquidity.
2. Loan Defaults
o High levels of non-performing assets (NPAs) constrain the bank's ability to
generate cash flows.
3. Market Value Depreciation
o Decline in the market value of assets due to adverse economic conditions.
4. Maturity Mismatches
o Holding long-term assets funded by short-term liabilities creates a mismatch,
leading to potential liquidity crunches.

b. Liability-Side Liquidity Risk

Arises when a bank is unable to meet its funding obligations.

1. Sudden Withdrawal of Deposits

o Large-scale withdrawal by depositors (e.g., during a bank run) strains
liquidity.
2. Over-Reliance on Short-Term Funding
o Heavy dependence on interbank borrowings or short-term wholesale funding
increases vulnerability.
3. Market Disruption
o Inability to roll over existing liabilities during market stress events.
4. Concentration Risk
o Dependence on a few large depositors or funding sources increases exposure
to liquidity risk.
5. High Leverage
o Excessive borrowing reduces financial flexibility and increases refinancing
risks.

4. Mitigation Strategies for Liquidity Risk

To manage liquidity risk, banks adopt several strategies, often aligned with regulatory
guidelines like those of the Reserve Bank of India (RBI) and Basel III norms.
a. Building Liquid Asset Buffers

 Maintain a stock of HQLA (e.g., treasury bills, government bonds) to meet short-term
obligations.

b. Diversification of Funding Sources

 Reduce dependence on a single source by diversifying into retail deposits, corporate

borrowings, and interbank funding.

c. Contingency Funding Plans (CFP)

 Develop robust plans to address potential liquidity crises, including backup credit
lines or asset sales.

d. Effective Asset-Liability Management (ALM)

 Match the maturities of assets and liabilities to minimize mismatches.

 Use ALCO (Asset-Liability Committee) oversight for continuous monitoring.

e. Regular Stress Testing

 Conduct periodic stress tests to identify vulnerabilities under adverse conditions.

f. Compliance with Regulatory Norms

 Maintain adequate LCR and NSFR as per RBI and Basel III guidelines.
 Adhere to CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio)
requirements.

1. Purchased Liquidity Management

Definition

Purchased liquidity management refers to obtaining external funds from the market to meet
liquidity needs. These funds are typically short-term borrowings or liabilities acquired
through interbank markets, debt issuance, or wholesale funding.

Key Features

 Relies on external funding sources.

 Helps maintain the bank's asset base by avoiding asset liquidation.
 May incur higher costs, especially during market stress.

Common Sources

1. Interbank Borrowings
o Borrowing funds from other banks, often at the overnight rate (e.g., repo markets).
 2. Certificate of Deposits (CDs)
o Short-term negotiable instruments issued to investors.
3. Commercial Paper
o Unsecured promissory notes issued to raise short-term funds.
4. Wholesale Deposits
o Large-value deposits from institutional investors.

Risks

 Increased reliance on market confidence.

 Higher costs during liquidity crises.
 Vulnerability to market disruptions.

2. Stored Liquidity Management

Definition

Stored liquidity management involves using the bank’s internal resources, such as liquid
assets or cash reserves, to meet liquidity demands.

Key Features

 Relies on internal reserves rather than external funding.

 Reduces dependency on volatile markets.
 May require liquidating assets, potentially at a loss.

Sources

1. High-Quality Liquid Assets (HQLA)

o Examples include government bonds, treasury bills, and cash.
2. Reserves with the Central Bank
o Cash held to meet statutory liquidity requirements.
3. Liquidation of Non-Core Assets
o Selling assets that are not essential to core operations.

Risks

 Asset liquidation may result in significant losses during stressed market conditions.
 Reduces the bank’s earning potential due to depletion of income-generating assets.

3. Liquidity Planning

Liquidity planning involves developing strategies and processes to ensure the bank can meet
its obligations under normal and stressed conditions.

Key Elements of Liquidity Planning

 1. Cash Flow Forecasting
o Predicting cash inflows and outflows to identify potential liquidity shortfalls.
2. Diversification of Funding Sources
o Reducing reliance on a single funding source.
3. Contingency Funding Plan (CFP)
o Preparing for unexpected liquidity demands through backup funding arrangements.
4. Liquidity Stress Testing
o Simulating adverse scenarios (e.g., deposit runs, market shocks) to evaluate
preparedness.
5. Monitoring Maturity Gaps
o Ensuring alignment between the maturities of assets and liabilities.

Benefits of Liquidity Planning

 Ensures proactive risk management.

 Enhances stakeholder confidence.
 Improves regulatory compliance.

4. Deposit Insurance

Definition

Deposit insurance is a system designed to protect depositors by guaranteeing the safety of

their funds up to a certain limit in the event of a bank failure.

Features of Deposit Insurance in India

 Governed by the Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary
of the RBI.
 Coverage Limit: Currently ₹5,00,000 per depositor per bank (as of 2024).
 Covers deposits such as savings, fixed, current, and recurring deposits.
 Funded through premium contributions by insured banks.

Advantages

1. Protects small depositors from losing their savings.

2. Boosts confidence in the banking system.
3. Helps mitigate bank runs.

Limitations

1. Limited coverage for high-value depositors.

2. Moral hazard for banks, as guaranteed protection may lead to riskier behavior.

5. Discount Window
Definition

The discount window is a facility provided by central banks (e.g., RBI in India, Federal
Reserve in the U.S.) that allows banks to borrow funds on a short-term basis to meet liquidity
shortages.

Key Features

 Provides emergency liquidity to banks during financial stress.

 Funds are secured by collateral, typically high-quality assets.
 Interest rates charged are often higher than the market rate to discourage over-reliance.

Types of Borrowing at the Discount Window

1. Primary Credit
o Short-term loans to financially sound banks.
2. Secondary Credit
o Loans to banks with temporary financial difficulties, subject to stricter terms.
3. Seasonal Credit
o Designed for banks facing seasonal fluctuations in liquidity, such as agricultural
lending institutions.

Benefits

 Stabilizes the financial system during crises.

 Reduces systemic risk by preventing contagion.

Risks

 Over-reliance on the discount window can indicate poor liquidity management.

 Stigma associated with using the facility may deter banks from accessing it.

Market Risk Management

Market risk refers to the potential for financial losses due to changes in market variables,
such as interest rates, exchange rates, equity prices, and commodity prices. It impacts both
the banking book and the trading book, and banks employ various models to quantify and
manage this risk.

1. Banking Book vs. Trading Book

Banking Book

 Definition:
Contains assets and liabilities held for long-term purposes, such as loans, deposits, and held-
to-maturity investments.
 Characteristics:
o Focuses on interest rate risk and liquidity risk.
 o Items are typically illiquid and less frequently revalued.
o Managed to match funding and earning strategies.
 Risks Addressed:
o Interest Rate Risk: Changes in interest rates affecting net interest income.
o Liquidity Risk: Maturity mismatches between assets and liabilities.

Trading Book

 Definition:
Consists of financial instruments held for short-term trading purposes, including equities,
derivatives, and foreign exchange.
 Characteristics:
o Marked-to-market daily to reflect current market values.
o High turnover due to active trading strategies.
o Managed to optimize profits from market movements.
 Risks Addressed:
o Price Risk: Changes in market prices of tradable instruments.
o Volatility Risk: Fluctuations in the market causing unpredictable outcomes.

2. Risk Metrics Models

The RiskMetrics Model

Developed by JP Morgan, this model provides a framework for measuring market risk,
particularly Value-at-Risk (VaR).

 Key Features:
o Relies on historical price data to calculate variances and covariances.
o Assumes normally distributed returns.
o Measures potential losses over a specified time horizon at a given confidence level.

 Steps Involved:

1. Calculate Variance-Covariance Matrix:

Measures the volatility of individual assets and their correlations.
2. Calculate Portfolio Variance:
Aggregates individual risks based on weights and correlations.
3. Compute Value-at-Risk (VaR):
Represents the maximum potential loss with a certain probability (e.g., 95%).

 Limitations:

o Assumes normal distribution, which may underestimate extreme risks.

o Does not account for non-linear risks, such as options.

3. Historic (Back Simulation) Model

Definition:

This approach uses historical data to estimate the potential losses in a portfolio by simulating
past market scenarios.

 Steps Involved:
1. Collect historical market price data for relevant assets.
2. Calculate daily portfolio values based on historical price changes.
3. Rank the historical changes and identify the potential loss at the desired confidence
level (e.g., 5th percentile for 95% confidence).

 Advantages:

o Does not assume any specific distribution of returns.

o Simple to implement and interpret.

 Limitations:
o Relies heavily on the availability and quality of historical data.
o May not accurately capture future extreme events (e.g., Black Swan events).

4. Monte Carlo Simulation Approach

Definition:

A statistical technique that uses random sampling to simulate potential future outcomes based
on predefined probabilities. It is widely used for complex portfolios and non-linear
instruments.

 Steps Involved:
1. Define the portfolio's assets and their characteristics (e.g., volatility, correlations).
2. Generate random scenarios for key risk factors (e.g., interest rates, stock prices).
3. Calculate portfolio values under each simulated scenario.
4. Aggregate results to estimate the distribution of potential portfolio outcomes.
5. Determine Value-at-Risk (VaR) or other risk metrics from the simulated outcomes.

 Advantages:

o Handles complex instruments, such as options, more effectively than simpler

models.
o Accommodates non-linear risks and non-normal distributions.

 Limitations:
o Computationally intensive, requiring significant processing power.
o Dependent on the quality of input assumptions, such as volatility and correlations.

Comparison of Risk Models

 Model Advantages Limitations

Simple and fast; effective for normal Assumes normal distribution; poor for
RiskMetrics Model
market conditions. extreme market events.

Historic (Back Reflects actual historical conditions; Limited by historical data; may not
Simulation) no distribution assumptions. predict future crises.

Monte Carlo Handles non-linear risks and complex Computationally demanding; quality
Simulation portfolios; very flexible. depends on input assumptions.

Regulatory Models and Risks in Banking

Regulatory models aim to ensure financial stability by setting standardized frameworks for
risk management and capital adequacy. The discussion encompasses the BIS Standardized
Framework, Off-Balance-Sheet Risk, Technology and Operational Risks, and
Securitization.

1. The BIS Standardized Framework

Definition

The Bank for International Settlements (BIS) Standardized Framework provides global
guidelines for risk assessment and capital adequacy for banks under the Basel Accords. It
primarily addresses credit, market, and operational risks.

Components

 Credit Risk Measurement

o Risk-weights are assigned to assets based on counterparty type and credit ratings.
o Simplified risk weights for retail loans, corporate loans, sovereign debt, and off-
balance-sheet exposures.
o Example:
 Sovereign debt rated AAA: Risk-weight 0%.
 Corporate loan rated BBB: Risk-weight 100%.

 Market Risk Measurement

o Covers risks from trading book activities such as foreign exchange, equities, and
commodities.
o Requires banks to maintain capital for Value-at-Risk (VaR) using standardized or
internal models.

 Operational Risk Measurement

o Risk of loss due to inadequate internal processes, people, systems, or external
events.
o Calculated using three approaches:

1. Basic Indicator Approach (BIA): Capital = 15% of average gross income.

 2. Standardized Approach (SA): Capital = weighted average of income from
various business lines.
3. Advanced Measurement Approach (AMA): Uses internal loss data and
models.

Advantages

 Ensures global comparability and transparency in risk measurement.

 Simplifies risk assessment for smaller banks without internal risk models.

Limitations

 Can over-simplify complex risk exposures.

 May not adequately capture idiosyncratic risks.

2. Off-Balance-Sheet Risk

Definition

Off-balance-sheet (OBS) activities involve financial obligations or exposures not recorded on

the bank's balance sheet. These include guarantees, derivatives, and securitized assets.

Key Types of OBS Activities

1. Guarantees and Letters of Credit

o Banks commit to fulfilling financial obligations if clients default.
2. Derivatives
o Instruments like options, futures, and swaps.
o Carry counterparty and market risks.
3. Loan Commitments
o Agreements to provide loans in the future.
4. Securitization Activities
o Transferring loan assets to third parties while retaining residual risks.

Returns and Risks of OBS Activities

 Returns:
o Earn fee income without increasing on-balance-sheet assets.
o Enhance profitability through derivative trading and securitization gains.

 Risks:
o Credit Risk: Default by counterparties in guarantees or derivatives.
o Market Risk: Losses due to changes in market conditions.
o Liquidity Risk: Cash flow pressures arising from OBS commitments.

Regulatory Considerations

 OBS activities are subject to capital requirements under Basel III.

  Risk-weighted exposure calculations for guarantees and derivatives.

3. Technology and Other Operational Risks

Definition

Operational risk refers to losses arising from failures in internal processes, people, systems,
or external events. Technology risk, a subset of operational risk, involves failures in IT
systems and cybersecurity breaches.

Key Sources of Operational Risks

1. Process Failures:
o Errors in transaction processing or reporting.
2. System Failures:
o Downtime in IT infrastructure, cybersecurity attacks, or data breaches.
3. Human Errors:
o Mistakes in loan approvals or trading.
4. External Events:
o Natural disasters, fraud, or regulatory changes.

Impact of Technology Risks

 Financial Losses: Due to system downtime or fraud.

 Reputational Damage: Loss of customer trust.
 Regulatory Penalties: For non-compliance with cybersecurity regulations.

Risk Mitigation Measures

 Robust IT Governance and incident response plans.

 Regular audits and stress testing of systems.
 Comprehensive cybersecurity frameworks to mitigate fraud.

4. Securitization

Definition

Securitization is the process of converting illiquid assets, such as loans or receivables, into
tradeable securities. It transfers credit risk from the originating bank to investors.

Key Steps in Securitization

1. Pooling of Assets:
o Grouping similar loans, such as mortgages or auto loans.
2. Special Purpose Vehicle (SPV):
o An entity created to hold the pooled assets.
 3. Issuance of Securities:
o SPV issues securities backed by the cash flows from the pooled assets.
4. Investor Returns:
o Investors receive interest and principal payments from the asset pool.

Types of Securitized Products

 Mortgage-Backed Securities (MBS): Backed by home loans.

 Asset-Backed Securities (ABS): Backed by credit card receivables or auto loans.
 Collateralized Debt Obligations (CDOs): Backed by diverse asset pools.

Advantages

 Frees up capital for banks to expand lending.

 Reduces credit risk on the bank’s balance sheet.
 Provides liquidity to illiquid assets.

Risks

 Credit Risk: Default on underlying loans.

 Market Risk: Price fluctuations in securitized products.
 Model Risk: Errors in estimating cash flows or defaults.

Regulatory Considerations

 Basel III requires banks to hold capital against retained securitization exposures.
 Transparency in securitization structures is emphasized to avoid systemic risk (lessons from
the 2008 financial crisis).