Chapter-03: Liquidity Risk

Management
Issues to be learned
 Understanding and defining Liquidity and

Liquidity Risk;
 Types and sources of LR;
 Liquidity Risk Measurement;

i. Contingency Funding Plans,

ii. Maturity Ladder;
iii. Liquidity ration and limits
 Liquidity Crisis, reasons and Impact;
 LR management Policies;
 LR management tools;
1
3.1 Understanding and defining Bank’s
Liquidity and Liquidity Risk

Liquidity is very critical phenomenon for

smooth operation of banking businesses. In
fact growth, development and survival
of banks depend on liquidity. It has
different meanings and connotations to
different parties and organizations which
makes it definition a very difficult task.

2
 3.1 Understanding and defining
Bank’s
Liquidity and Liquidity Risk
In reality, banks have various ways to obtain
liquidity. They can hold central bank reserves, borrow
in the interbank market, borrow within their banking
group, or simply invest in government bonds.
Considering only one liquid asset is therefore at odds
with industry practice and, importantly, makes it
difficult to ascertain the extent in which frictions in
one market for liquidity spills over to other markets.
3
Contd.
The problem of moral hazard can perhaps
be most effectively addressed by prudential
supervision and regulation that ensures that
financial institutions manage their liquidity
risk effectively in advance of the crisis.”
(emphasis added)

– Ben Bernanke, May 2008, Sea

Island Resort and Spa
4
3.2 defining Bank’s Liquidity

Liquidity is the solvency capacity of business

entities or bank and which has special
reference to the degree of readiness in which
assets can be converted into cash without any
loss. Liquidity risk is the danger of having
insufficient cash to meet a bank’s obligations
when due (Rose, Peter S.2005).

5
 Contd.
Liquidity is a 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.
It is a term used to refer to how easily an
asset or security can be bought or sold in
the market. It basically describes how
quickly something can be converted to
cash.

6
3.3 Understanding and defining
Liquidity Risk

Liquidity risk is the probability of loss to a

Financial institution arising from a situation
where‐
 there will not be enough cash and/or cash
equivalents to meet the needs of depositors
and
borrowers;
 sale of illiquid assets will yield less than their
fair value; or
 illiquid assets cannot be sold at the desired time
due to lack of buyers.

7
 Contd.
Liquidity risk is the risk that a business will not have
sufficient cash to meet its financial commitments in a
timely manner. Without proper Cash Flow
Management and sound liquidity risk management,
a business will face a liquidity crisis and ultimately
become insolvent.

RQ: Current Liquidity crisis of some banks of

Bangladesh.

8
Contd

Liquidity risk is the inability of a bank to meet its

obligations as they become due, without adversely affecting
the bank’s financial condition. A major risk a bank runs is
liquidity risk. Banks must honor their commitments by making
sure that there is enough liquidity to meet funding requirements.

Liquidity risk management is today a major focus for

regulators, due to increasing complexity of financial markets and
concerns related to inadequate identification and managing
liquidity risk, exacerbated (Problematic situation) by the financial
crisis.
To ensure adequate liquidity, banking companies must monitor
the GAP between assets and liabilities in terms of maturities.

9
 Contd.
If the maturity mismatch (GAP) in any period
(e.g., month, quarter) is too large relative to a
liquidity cushion / lessen(e.g., SLR, core capital),
the Asset/Liability Committee (ALCO) must take
decisions to rectify the situation. Otherwise, the bank
may be forced to seek relatively expensive “money at
call” borrowings or even require BB intervention.
Liquidity risk can be sub-divided into
 funding liquidity risk and
 asset liquidity risk.
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 3.4 Why is LRM important to banks?

Effective 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.
Effective liquidity risk management begins
with the establishment of a comprehensive
and strong internal governance process for
identifying, measuring and controlling
liquidity risk exposure. The LRM
infrastructure naturally considers business-
as-usual, firm-specific scenarios and stress-
test environments.
11
 Contd.
Liquidity risk is often triggered by the
consequences of other financial risks such
as credit risk, interest rate risk etc. For
instance, a large loan default or changes in
interest rate can adversely impact an FI's
liquidity position.

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3.4 Types of Liquidity Risk

There are two different types of liquidity risk. The

first is funding liquidity or cash flow risk,
while the second is market liquidity risk, also
referred to as asset/product risk.
Funding or cash flow liquidity risk is the
major concern of a corporate treasurer who
asks whether the firm can fund its liabilities. A
classic indicator of funding liquidity risk is the
current ratio (current assets/current liabilities)
or, for that matter, the quick ratio.
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i) Funding Liquidity Risk

Funding liquidity risk is a specific type of

liquidity risk that arises when an
organization cannot obtain the necessary
funding to meet its financial obligations. For
example, this can happen when an
organization’s lenders or investors withdraw
their support or when borrowing costs rise
significantly.
A classic indicator of funding liquidity risk
is the current ratio (current assets/current
liabilities) or, the quick ratio.

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ii) Market Liquidity Risk
Market or asset liquidity risk is asset
illiquidity. This is the inability to easily exit a
position. For example, we may own
real estate but, owing to bad market
conditions, it can only be sold imminently at
a fire sale price. The asset surely has value,
but as buyers have temporarily evaporated,
the value cannot be realized.

15
 Contd.

Besides, liquidity risk can be classified into

four categories:
a. Term liquidity risk (due to mismatch of
maturities);
b. Withdrawal/call risk (mass disinvestment
before maturity);
c. Structural liquidity risk (when the
necessary funding transactions cannot be
carried out or carried out at less favorable
terms); and
d. Market liquidity risk.
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 3.5 Sources of Liquidity Risk
Some common sources of LR include:
1. Lack of Cash Flow Management
Cash flow management gives a business good visibility into
potential liquidity challenges and opportunities. Cash is king,
and cash flow is the bloodline of all businesses. Without proper
management of cash flow, a business will increase its exposure
to unnecessary liquidity risks. Moreover, a business without
healthy and well-managed cash flow will face an uphill battle
to remain profitable, secure favorable financing terms, attract
potential inventors and be viable in the long run.

17
 Contd.
2. Inability to Obtain Financing
A history of late debt repayment and/or non-
compliance with loan covenant requirements
may translate into additional challenges
when attempting to secure financing.
Therefore, it is imperative that businesses
have good capital structure management,
match debt maturity profiles to assets, and
maintain a good relationship and regular
communication with lenders. The inability to
obtain funding at all or to obtain it at
competitive rates and acceptable terms
increases liquidity risk.
18
 Contd.
3. Unexpected Economic Disruption
At the start of 2020, the stock market was
at its all-time high, and few people
expected the world would be so hard hit by
COVID-19. The adverse economic impact of
this global pandemic was swift and
relentless. Lockdowns created an
unexpected economic disruption, and many
businesses saw sales dwindle to a
catastrophically low level and liquidity risk
drastically increase.

19
Contd.
4. Unplanned Capital Expenditures
Having proper fixed asset management is
extremely important, particularly for a business
that operates in a capital-intensive industry
such as energy, telecommunications or
transportation. A capital-intensive business is
often highly leveraged with a high fixed to
variable costs ratio. For businesses like these, a
single unplanned capital expenditure, such as a
new purchase or major equipment repairs, may
exacerbate existing budget constraints. This, in
turn, further increases operating leverage and
heightens liquidity risk.

20
 Contd.
5. Profit Crisis
A business in a profit crisis will not only see
a decline in its profitability margins but also
a decline in its top-line revenue.
Consequently, to combat negative
profitability margins and remain in
operation, it will need to start dipping into
cash reserves. Failure to stop a continuous
cash burn will eventually deplete cash
reserves, with the business inevitably facing
a liquidity crisis.

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Besides, other sources of LR are as
follows:
 1 Abnormal behavior of financial markets
 2. Unanticipated change in cost of capital
 4. Range of assumptions used
 5. Risk activation by secondary sources
 6. Break down of payments system
 7. Macroeconomic imbalances
 8. Contractual forms
 9. Financial Infrastructure deficiency

22
 Contd.
Some factors increasing liquidity risk,
these are:
 Erosion of confidence in a bank within the

marketplace because of earnings difficulties

or other reasons.
 Depending on one market or on a few

counter-parties for deposits.

 Unstable financial markets and
 Extensive ‘short’ borrowing or ‘long’ lending

operations.

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 Some factors are reducing liquidity
risk, these are:
 Availability of related party funding
 Maintenance of a high level of liquid assets
 Government deposit insurance, if any and
 Maintenance of a closely matched, as

possible, maturity structure between assets

and liabilities.

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Contd
 Contingency Funding Plans In order to
develop comprehensive liquidity risk
management framework, FIs should have
plans in place to address stress scenarios.
This is commonly known as Contingency
Funding Integrated Risk Management
Guidelines for Financial Institutions| Plan
(CFP). CFP is a set of policies and
procedures that serves as a blueprint for an
FI to meet its funding needs in a timely
manner and at a reasonable cost.

25
 3.6 Liquidity Risk Management
Techniques of LRM
i) Contingency funding plan (CFP)- In order
to develop comprehensive liquidity risk
management framework, FIs should have plans
in place to address stress scenarios. This is
commonly known as Contingency Funding Plan
(CFP). CFP is a set of policies and procedures
that serves as a blueprint for an FI to meet its
funding needs in a timely manner and at a
reasonable cost.
Institutions use CFPs to develop and
implement their financial and operational
strategies for effective management of
contingent liquidity events. 26
 ii) Maturity Ladder
FIs may utilize flow measures to
determine their cash position. A
maturity ladder estimates an FI's cash
inflows and outflows and thus net deficit or
surplus (gap), both on a day‐to‐day basis
and over a series of specified time periods.
FIs need to focus on the maturity of its
assets and liabilities in different
tenors. Mismatch accompanied by liquidity
risk and excessive longer tenor lending
against shorter‐term borrowing can put an
FI's balance sheet in a very critical and risky
position.
27
 Contd.
To address this risk and to make sure an FI
does not expose itself in excessive
mismatch, a bucket‐wise maturity
profile of the assets and liabilities to
be prepared to understand mismatch
in every bucket.
If you could buy five bonds that mature in
1, 2, 3, 4, and 5 years. As the first bond
matures, investors reinvest the proceeds in
a new five-year bond. This process repeats
itself with each maturity. Thus, the maturity
length of the ladder is maintained.
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 Example
To set up a 5-year bond ladder with $1,000
to invest, for example, you would buy five
bonds for $200 each that mature in 2023 to
2028. Once the 2023 bonds mature, you
can stay invested by buying a 2029 bond
with the proceeds.

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iii) Liquidity ration and limits
FIs may use a variety of ratios to quantify
liquidity. These ratios can also be used to create
limits for liquidity management. However, such
ratios would be meaningless unless used
regularly and interpreted considering qualitative
factors.
A ratio of one indicates that a company's current
assets are sufficient to cover all of its current
obligations. A ratio of less than one indicates
that a corporation is unable to meet its present
liabilities. A ratio larger than one indicates that a
corporation can pay its existing debts.

Current Ratio, Quick Ratio, etc.

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3.7 Liquidity Risk Measurement tools

There are several ways of measuring liquidity risk,

namely:
1. Analysis of Financial Ratios
2. Cash Flow Forecasting
3. Capital Structure Management
i) Debt-to-Equity Ratio
ii) DuPont Analysis

Return on equity (ROE) is a profitability ratio that

measures the rate of returns generated by invested

equity (i.e., common stock). A higher ROE usually means

that a business is more efficient in generating returns than its

peers; a lower ROE means the opposite. DuPont analysis breaks

down ROE into three components: 31

Contd.

1. Analysis of Financial Ratios-

for liquidity risk measurement
purpose, some widely used financial
ratios are:
 Loan to Deposit ratio
 Loan to Liability Ratio
 Asset to liability ratio

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 Loan to deposit ratio:
When the loan to deposit ratio rises , banks are
thought to be less liquid , when the ratio falls ,
banks are thought to be more liquid.
 Loan to liability ratio:
The advantage of this measure over loan to deposit
ratio is the recognition that liabilities other than
deposits can also represent a potential drain on
funds at banks.
Liquid asset to liability ratio:
Use of this measure allows assets to be selected on
the basis of their liquidity , whether there are loans
or investment. The most serious shortcomings is
that this ratio measures only asset liquidity ignoring
the liquidity available through a banks ability to
borrow. Moreover it does not take account of the
composition problem.
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2. Cash Flow Forecasting
Cash flow forecasting is the process of estimating
the flow of cash in and out of a business over a
specific period of time. An accurate cash flow
forecast helps companies predict future cash
positions, avoid crippling cash shortages, and earn
returns on any cash surpluses they may have in the
most efficient manner possible.

Both finance and treasury teams are

primarily responsible for forecasting cash
flows. They collect all required data from different
business stakeholders and a variety of financial and
other systems and combine them to run analyses
on future cash positions at certain given times.

34
 Contd.
Typically, there are three different time
horizons for cash forecasting:
 Short-term cash flow forecasting

Short-term cash flow forecasting is for a

period of thirty days from the moment you start
running the forecast. They provide you with a
good day-to-day breakdown of cash receipts and
payments of different bank accounts.


35
 Contd

 Medium-term cash flow forecasting

Medium-term cash flow forecasting estimates forecasts
over a period of one month to six months or even a
year. It provides a better picture of average cash
positions instead of day-to-day breakdowns as with
short-term forecasting
 Long-term cash flow forecasting
Long-term cash flow forecasting typically covers
periods exceeding one year. It includes long-term
expected in- and outflows. The longer the period of the
forecast becomes, the less reliable the outcome is. Yet,
some cash flows can be predicted over a longer period
of time, such as longer-term repayment schedules,
interest payments, and other stable in- or outflows.

36
3. Capital Structure Management

i) Debt-to-Equity Ratio

ii) DuPont Analysis

i) Debt-to-Equity Ratio-

37
 ii) DuPont analysis
The DuPont analysis is an expanded return on
equity formula, calculated by multiplying the
net profit margin by the asset turnover by the
equity multiplier.
DuPont analysis is a framework for analyzing
fundamental performance originally
popularized by the DuPont Corporation,
now widely used to compare the
operational efficiency of two similar firms .
DuPont analysis is a useful technique used to
decompose the different drivers of return on
equity (ROE).

38
Contd.

39
3.8 Liquidity Crisis, reasons and Impact

In practice, the banks regularly find

imbalances (gaps) between the asset and
the liability side that need to be equalized
because, by nature, banks accept liquid
liabilities but invest in illiquid. If a bank
fails to balance such a gap, liquidity risk might
occur, followed by some undesirable
consequences such as insolvency risk,
government bailout risk, and reputation risk.

R.Q What are the prime cause of bank’s

Liquidity Crisis?

40
 Contd.
The failure or inefficiency of liquidity management
is caused by the strength of liquidity pressure, the
preparation of a bank’s liquid instruments, the
bank’s condition at the time of liquidity pressure,
and the inability of the bank to find internal or
external liquid sources.

The below lists some internal and external

factors in banks that may potentially lead to
the liquidity risk problems.

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 i) Internal Banking Factors
 High off-balance sheet exposures.
 The banks rely heavily on the short-term

corporate deposits
 A gap in the maturity dates of assets and

liabilities
 The banks’ rapid asset expansions exceed the

available funds on the liability side

 Concentration of deposits in the short term

Tenor
 Less allocation in the liquid government

instruments
 Fewer placements of funds in long-term

deposits.

42
ii) External Banking Factors
 Very sensitive financial markets depositors
 External and internal economic shocks
 Low/slow economic performances.
 Decreasing depositors’ trust on the banking
sector.
 Non-economic factors
 Sudden and massive liquidity withdrawals from
depositors
 Unplanned termination of government
deposits

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 3.9 Risk mitigation strategies
The banks should consider putting in place certain

prudential limits to avoid liquidity crisis:

1. [

1. Cap on inter-bank borrowings, especially call borrowings;

2. Purchased funds vis-à-vis liquid assets;

2. 3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity
Reserve Ratio and Loans;
4. Duration of liabilities and investment portfolio;
5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches
across all time bands;
6. Commitment Ratio – track the total commitments given to
Corporates/banks and other financial institutions to limit the off-balance sheet
exposure;
7. Swapped Funds Ratio, i.e. extent of BDT raised out of foreign currency
sources .
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 3.10 L. Risk management
Policies
Board of Directors should ensure that there are
adequate policies to govern liquidity risk
management process. While specific details vary
across institutions according to the nature of their
business, key elements of any liquidity policy
includes:
i) general liquidity strategy (short and long‐term),
specific goals and objectives in relation to
liquidity risk management, process for strategy
formulation and the level it is approved within the
institution;

45
 Contd.
ii) roles and responsibilities of individuals
performing liquidity risk management functions,
including structural balance sheet management,
pricing, marketing, contingency planning,
management reporting, lines of authority and
responsibility for liquidity decisions;
iii) liquidity risk management structure for
identifying, monitoring, reporting and reviewing
the liquidity position;
iv) liquidity risk management tools (including
the types of liquidity limits and ratios in place
and rationale for establishing limits and ratios);
and e. contingency plan for handling liquidity
crises.
46
 To be effective, the liquidity policy must be
communicated down the line throughout
the FI.
It is important that the board and senior
management ensure that policies are
reviewed on a regular basis (at least
annually) and when there are any material
changes in the FI's current and prospective
liquidity risk profile. Such changes could
stem from internal circumstances (e.g.
changes in business focus) or external
circumstances (e.g. changes in economic
conditions).

47
3.12 Measuring liquidity risk
i) Stress testing
Stress testing is based on the Bank’s
expected cash in- and outflows during the
twelve-month horizon. The Target Liquidity
Requirement is then calculated by applying
the stress scenario on the expected cash in-
and outflows and the Liquidity Buffer. The
stress test captures both market-wide and
particular risk effects.
48
 Contd.
ii) Liquidity Buffer
The Liquidity Buffer consists of cash, innovative/
creative bonds and money market securities as
well as deposits. The Liquidity Buffer is mainly
invested in EUR, USD and the Nordic currencies.
In addition, other currencies will be used if it is
deemed necessary for fulfilling upcoming
payment obligations. The Bank shall be able to
fulfil the expected net cash outflows of the
forthcoming three months with maturing
investments from the Liquidity Buffer.

49
 Review Questions
 Define the terms ‘Liquidity’, ‘Liquidity Risk’ and ‘Liquidity Risk
Management’ .
 Why does Liquidity Risk Management matter in bank and Fis?
 State the sources, causes and types of Liquidity Risk.
 What are the prime cause of a bank’s Liquidity Crisis?
Explain.
 Discuss various Liquidity Risk Management tools.
 State the key elements of any liquidity policy
 List out internal and external factors in banks that may
potentially lead to the liquidity risk problems.
State the key elements of any liquidity policy

 Short notes :
a) Contingency Funding Plan; b) Maturity ladder;
c) Stress testing ; d) Liquidity Buffer, e)

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