Liquidity Risk Management &

Cost of Funds

Maneesh Raj

Agenda Liquidity Risk Understanding Liquidity & Liquidity Risk Liquidity Needs Estimation Liquidity Risk Management BCSB Principles Relating to LRM in Banks

Cost of Funds Basic Concepts & Components PLR & Base Rates

Understanding Liquidity & Liquidity Risks in Banks

Object of ALM Policy • Ensuring Profitability • Ensuring Liquidity Banks borrow ‘short’ and lend ‘long’

This ensures ‘price matching’ but may lead to ‘liquidity mismatch’

Management of Liquidity Risk and Interest Rate Risk go hand-in-hand but with a difference in

approach.

Cash Assets of Banks

• Banks own four types of cash assets : - Vault Cash - Demand Deposit Balances with RBI - Demand Deposit Balances with Other FIs - Cash Items in the Process of Collection(Float)

Why do Banks hold Cash ?

Why do Banks hold Cash ?

• Enable customers to do regular transactions• To meet mandates of Regulators• To serve nation’s Check Payment System• To purchase services from correspondent banks

However, Cash Assets do not generally

satisfy a Bank’s Liquidity Needs

What is Liquidity ?

Can convert to cash quicklyLow transaction cost to liquidate Does not move the market upon conversion

Qualities of a Liquid Asset

Two Facets of Liquidity ?

• Market Liquidity : easy to trade / low bid-ask spread small price-impact easy search / adequately available

• Funding Liquidity : funding from own capital funding from collateralized loans funding from “Market”

So, what is Liquidity Risk ?

• Market Liquidity Risk: - Risk that the market liquidity worsens when

you like to trade

• Funding Liquidity Risk: - Risk that a trader cannot fund his position

and is “forced” to unwind

Liquidity – Credit – Interest Rate Risk

Poor Liquidity Mismatched A/L maturities & Durations or by extending credit to high risk borrowers

High NPA / Reduced earnings

Negative Outlook in Market

Higher Rates to attract deposits / funds

Further Decline / Reduced Margins / non accruing loans / spiral effect

Liquidity Versus Profitability

• There is a short-run trade off between Liquidity and Profitability.

• Both Asset & Liability Liquidity contribute to this trade-off.

Liquidity Needs Measurement

Estimation of Liquidity

• Loan compartments made• Based on historic al trends,

future flows are estimated• Economic levels are also

factored in• Cyclic trends are established

1. Sources and Uses of Funds Method

• Sources and Uses of funds are studied / estimated• “Maturity Ladders” are constructed• Market access designed• Contingency plans drawn

Estimation of Liquidity 2. Structure of Deposit Method

• List all types of deposits at the bank• Assign “probability of withdrawal”• Arrive at withdrawable fund in planning horizon

Deposit Type Amount Held (Rs 000 Cr)

Probability Of withdrawal

Withdrawals

Demand Deposits 5 0.90 4.50

Other Demand Deposits 10 0.70 7.00

Savings Deposits 100 0.40 40.00

Term Deposits 50 0.20 2.00

Expected Deposit Withdrawals 53.50

Liquidity of Future Stocks

• their potential marketability, • the extent to which maturing asset /liability

will be renewed, • the acquisition of new asset / liability and • the normal growth in asset / liability accounts

Considerations while determining liquidity of the bank’s future stock of assets & liabilities

Liquidity Risk Ratios

• Loans to Total Deposits• Loans to Non Deposit Liabilities• Loans to Core Deposits• Unencumbered Liquid Assets/nondeposit liab.• Purchased Funds to Total Assets• Loan Losses / Net Loans (Net NPA %)

Asset Liquidity Measures

• Cash & Dues from Banks• Due from Banks • Treasury Securities• Corporate Obligations – maturing before 1 yr• Loans - easily sold / securitized

Liquidity Risk Management

Development of Liquidity Concept

• Short term self-liquidating loans (prior to 1930)• Shiftability Theory (1930-1950)• Anticipated Income Theory (1950)• Liability Management Theory

Now banks use comprehensive ALM to meet its Liquidity requirements.

Levels of LR Management

• Day-to-Day (up to a week)• Ongoing Cash flow Mgmt (up to 3 months)• Structural Liquidity (up to five years)

Catastrophic / Stress Liquidity Mgmt

Approaches - Liquidity Risk Management

• Fundamental Approach • Technical Approach

Though the two methods distinguish strategically, they supplement each other.

Fundamental Approach (1/3)

“ Liquidity can be imparted in the system either by Liability Creation or by Asset Liquidation.”

Asset Management :

- Aims to eliminate liquidity risk by holding near cash assets - Primary Assets will be the second to be utilized - Secondary Line of Defense : Unsecured Marketable Sec.

Fundamental Approach (2/3)

Liability Management

- focuses on the sources of funds - bank doesn’t maintain any surplus of funds - adheres to raising funds whenever so required

Asset Management Strategy emphasizes on the best deployment of funds , whereas Liability Management tries to achieve the same through mobilizing Additional funds.

Fundamental Approach (3/3)

• Historically, primary means• Involves instantaneous

generation of liquidity by assets-liquidation

• Newer Concept• Involves acquisition of

external funds when liquidity needs arises

Asset Liquidity Management Liability Liquidity Management

• Liquid Assets plays 2 roles : 1. Alternative source of funds2. Acts as Secondary Reserves It also boosts investors

confidence in the bank.

• Assets can be shifted from high earning instruments

• Greater Asset diversification Enhances: Interest Rate,

Capital Mkt & Financial Risks

Technical Approach

• Focus is on Cash Flows Position• Working Funds Approach - Volatile funds - Vulnerable funds - Stable funds• Cash Flows Approach

Working Funds Approach (1/4)

• Working Funds = owned + deposits + float• Liquidity requirements for each component is

assessed (consolidated or segmented)

Component Liquidity Nature - Owned (capital) Nil - Deposits Variable - Float Variable

Working Funds Approach (2/4)

• Deposits Nature Liquidity Required - Volatile 100 % - Vulnerable < 100 %, depends on policy - Stable lower, ----- do ------• Floats - Similar to Deposits, mix of stable & variable

Working Funds Approach (3/4) Flow of Working Funds Approach

Determine Objective

Lay down the range of variance

Lay down the Avg Cash & bank balances to be maintained as % of total Working Funds

Collect Historical Data

Components of Working Funds

Working Funds Approach (4/4)

• Classifying deposits is a subjective decision

• Ignores potential deposits / flows

Limitations of the Approach

Cash Flows Approach (1/4)

Important Parameters :

- Planning horizon for the forecasts

- Cost Involved in forecasting

Cash Flows Approach (1/4) Flow of Working Funds Approach

Estimate Anticipated changes in deposits

Forecast on historical trends

Estimate the cash outflows : by deposit withdrawals & Credit accommodations

Estimate cash inflows by recovery

Determine Planning horizon of forecast

Estimate Liquidity Required

Liquidity Gap Report

Determine the number of time buckets

Determine the length of each bucket

Slot every asset, liability and off balance sheet item into a corresponding bucket

Compute the gap

Compute the cumulative gap and other related measures

Steps in Preparing a Gap Report

Liquidity Gap Report

• Under normal business conditions or going concern scenarios.

• Under bank or organization specific problems (such as inability to roll-over its deposits or withdrawal of deposits before maturity).

• Under general crises conditions (such as bank may not be able to raise funds from disposal of near liquid assets such as marketable securities).

Other Related Concepts

• Liquidity Planning Vs Reserve Requirements • Managing Floats (BoNY, Nov 20,1985)• Managing Correspondent Balances• Securitization as provider of liquidity

• LAF (Liquidity Adjustment Facility) of RBI

BCSB Principles for the Assessment of Liquidity Management in Banks

BCSB Principles for the Assessment of Liquidity Management in Banks

• Developing a Structure for Managing Liquidity• Measuring and Monitoring Net Funding

Requirements• Managing Market Access• Contingency Planning• Foreign Currency Liquidity Management• Internal Controls for Liquidity Risk

Management• Role of Public Disclosure in Improving Liquidity

BCSB Principles

• Principle 1 : Adopt an agreed strategy for the day-to-day management of liquidity.

• Principle 2: Board of directors to approve the strategy and significant policies related to the management of liquidity. The board should also ensure that senior management takes the steps necessary to monitor and control liquidity risk.

• Principle 3: Each bank should have a management structure in place to execute effectively the liquidity strategy. Banks should set and regularly review limits on the size of their liquidity positions over particular time horizons.

• Principle 4: A bank must have adequate & timely information systems for measuring, monitoring, controlling and reporting liquidity risk.

Developing a Structure for Managing Liquidity

BCSB Principles

• Principle 5: Each bank should establish a process for the ongoing measurement and monitoring of net funding requirements.

• Principle 6: A bank should analyse liquidity utilising a variety of “what if” scenarios.

• Principle 7: A bank should review frequently the assumptions utilised in managing liquidity to determine that they continue to be valid.

Measuring and Monitoring Net Funding Requirements

BCSB Principles

Principle 8: Each bank should periodically review its efforts to establish and maintain relationships with liability holders, to maintain the diversification of liabilities, and aim to ensure its capacity to sell assets

Managing Market Access

BCSB Principles

Principle 9: A bank should have contingency plans in place that address the strategy for handling liquidity crises and include procedures for making up cash flow shortfalls in emergency situations.

Contingency Planning

BCSB Principles

• Principle 10: - Measurement, monitoring and control system for its liquidity

positions in the major currencies in which it is active. - A bank should also undertake separate analysis of its

strategy for each currency individually.

• Principle 11: Set and regularly review limits on the size of its cash flow mismatches over particular time horizons for foreign currencies in aggregate and for each significant individual currency in which the bank operates.

Foreign Currency Liquidity Management

BCSB Principles

Principle 12: • Develop adequate system of internal controls over its

liquidity risk management process. • Regular independent reviews and evaluations of the

effectiveness of the system and• The results of such reviews should be available to

supervisory authorities

Internal Controls for Liquidity Risk Management

Measuring Cost of Funds

3-6-3 Method to Run a Bank

• In highly regulated banking environment worldwide :

- Liability Management was routine - Customers had hardly any choice - Customers were loyal

So, the Golden Rule was : Pay 3 % on deposits, charge 6 % on loans and hit the golf course at 3 o’clock

Major Components

• Cost of acquiring funds• Cost of admin. Overheads & Operational costs• Cost attached with making loans• Costs attributable to Risk factors• Related Considerations (profitability goals etc)

Methods of Computing Cost of Funds

• Average Cost of Funds• Marginal Cost of Funds• Match Funding

Average Cost of Funds

Methods of Computing Cost of Funds

• Avg historical costs are taken for pricing decisions

• Historical interest expenses are clubbed with non-interest expenses

• They don’t take future costs into consideration• Theory assumes that the interest rate will be

constant at historical levels

1. Average Cost of Funds

Methods of Computing Cost of Funds

- A measure of borrowing cost to acquire one additional unit of investable funds

- Rising Rate : Marginal Cost > Historical costs Falling Rate : Marginal Cost < Historical Costs

- Marginal Cost = ( forecasted Interest Rate + Servicing Cost + Acquisition cost + Insurance) / (1-% of funds in nonearning assets)

2. Marginal Cost of funds

Sources of funds & their costs

• Owned Capital : Direct Cost : Opportunity Cost : say, 8.00 %

• Reserve Requirements Present C.R.R. : 6.00 % Opportunity Cost : 0.50 %

6.50 %

Sources of funds & their costs

• Deposits

Current Accounts : Nil, but highly volatile Savings Accounts : 3.50 % Term Deposits : Market determined

• Deposits Insurance

Premium Charged : 1.25 %

Sources of funds & their costs

• Borrowals : - From RBI : Repo Auction : 5.25 % - Call Money : 4.00 % - Money Market Borrowal: say, 5-6 %

Sources of funds & their costs• Costs on Bad Debts: - Provisions - Capital Charges - Carry Costs - Opportunity Costs - Higher Risk Premium

Calculate : Weighted Avg Cost of all items Add : Risk Premium Add : Administrative & Operational costs

A Typical Risk-based Pricing

7.5%8.1%

14.2%13.6%

11.0%10.7%10.2%

9.3%

12.3%11.8%

11.0%

12.8%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8

Co

st a

nd

Pri

cin

g

Cost of funds Costs + Premium PLR Existing Pricing

Costs = 7.3%

Risk Premium

10.25% [PLR]

A Typical Risk-based Pricing

9.5%8.9%

10.7%

11.5%12.1%

12.4%

15.0% 15.6%

12.8%

11.0%

11.8%12.3%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

SB1 SB2 SB3 SB4 SB5 SB6 SB7 SB8

Co

st

an

d P

ricin

g

Cost of funds Costs + Premium Proposed Pricing

PLR Existing Pricing

Risk Premium

Costs = 7.3%

10.25% [PLR]Spread

BPLR Vs Base Rate ?

Base Rate will include • the card interest rate on retail deposit - deposits below

Rs. 15 lakh with one year maturity - adjusted for CASA deposits

• adjustment for the negative carry in respect of CRR and SLR

• unallocated overhead cost for banks which would comprise a minimum set of overhead cost elements

• average return on net worth.

Thank You !

Depositor’s Panic - Incidences

• April 13,2003 : ICICI, Rs 250 Cr withdrawal ; RBI came defending ICICI’s strength• Feb. 11, 2002 : Bank of Punjab• 2002 : Many cooperative banks were run. Ex : General Cooperative Bank (Gujarat) Suryapur Cooperative Bank (Surat) Diamond Jubilee Bank (Surat)

• Nov 20, 1985Bank of New York, a $ 16 bn firm, finds that the bank was deficient

in its required reserve holdings by $ 23.60 bn.

• 1984 : Continental Illinois Bank • 1991 : Bank of New England

• 2007-08 : During Subprime Crisis, Liquidity Crunch was one of the most major factors