FIN925 Report Danial Munsoor 3259882 Zara Khan 3189727

Table of Contents Synopsis ........................................................................................................................ 1

1. Introduction ............................................................................................................. 2

2. Measuring Liquidity Risk ....................................................................................... 3

2.1 GAP Analysis ..................................................................................................... 3

2.2 Liquidity Ratio ..................................................................................................... 4

2.3 Net Loans to Total Assets Ratio ......................................................................... 5

2.4 Loans to Deposits (LTD) Ratio ........................................................................... 5

3. Managing Liquidity Risk ........................................................................................ 6

3.1 Corporate Governance ....................................................................................... 6

3.2 Strategies & Policies .......................................................................................... 6

3.3 Determining Risk Limits ..................................................................................... 7

3.4 Internal control ................................................................................................... 8

3.5 Active management of intraday liquidity positions .............................................. 8

3.6 Scenario/Stress testing ...................................................................................... 9

3.7 Contingency funding planning ............................................................................ 9

3.8 Reporting Requirements .................................................................................. 10

4. Conclusion ............................................................................................................ 11

5. References ............................................................................................................ 13

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Synopsis

Liquidity risk is the risk that arises when the company has insufficient financial

resources available to meet all its obligations and commitments as they fall due.

Therefore, the company should try to maintain adequate liquidity at all times, in all

geographic locations and for all currencies, so that it is in a position to meet all

obligations as they fall due. In order to maintain adequate liquidity at all times, the FI

must measure the risk associated with its liquidity so that it is able to provide a cushion

against the capital outflows. Some of the most common methods of measuring liquidity

risk include Liquidity GAP Analysis, Liquidity Ratio, Net Loans to Total Assets Ratio and

lastly Loans to Deposits Ratio. Liquidity risk once measures needs to be managed

appropriately. Several principles have been laid out by literature to assist banks and

other financial institutions in effectively managing the liquidity risk. These include

establishment of effective corporate governance, involvement of management in

devising risk policies, strategies and setting risk limits, internal control of the liquidity risk

management framework, active management of intraday liquidity position, stress

testing, contingency funding planning and meeting reporting requirements. All these

concepts and principles need to be well understood and implemented in banks.

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1. Introduction: Liquidity risk is the risk that arises when the company has insufficient financial

resources available to meet all its obligations and commitments as they fall due. In other

words, it is the probability of loss arising from an event where (1) there will not be

sufficient cash and/or cash equivalents to meet the needs of depositors and borrowers,

(2) proceeds from illiquid assets will yield less than their fair value, or (3) illiquid assets

will not be sold at the desired time due to lack of buyers (Business Dictionary, 2010).

The Liquidity Risk associated with Financial Institutions (FI’s) is mainly the probability

that depositors (or lenders) will want to withdraw their funds. This is referred to as the

Capital Outflow (or Deposit Drain). Such a situation mainly arises when the actual

liquidity needs are more than the predicted liquidity needs. Therefore, the company

should try to maintain adequate liquidity at all times, in all geographic locations and for

all currencies, so that it is in a position to meet all obligations as they fall due (Standard

Chartered Annual Report, 2008). If the bank or the FI is not able to meet the liquidity

requirements, it may be exposed to additional costs. It may have to cut down on its new

loans, which will adversely affect the profitability of the bank. Moreover, it may also have

to sell some of its non-liquid assets at a loss. In the worst case scenario, the bank will

not be able to provide for the agreed or the promised payment, for example the

withdrawal request will be refused or a loan commitment will not be honored. This will

reduce the confidence in the bank, and will also have a negative impact on the stability

of its financial system (Hogan, 2004: 191). Therefore, many leading financial institutions

have taken steps to enhance the visibility of liquidity risk and have also created

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integrated risk management frameworks that expand the responsibility for liquidity risk

measurement and management (Ernst and Young, 2009).

2. Measuring Liquidity Risk: In order to maintain adequate liquidity at all times, the FI must measure the risk

associated with its liquidity so that it is able to provide a cushion against the capital

outflows. There are various ways of measuring liquidity risk, but some of the primary

and most commonly used measures include:

2.1 GAP Analysis:

In order to limit our exposure to liquidity risk, banks must monitor the Liquidity Gap

between assets and liabilities in terms of maturities. Banks need to match the

maturities of the assets with the maturities of our liabilities, so that the funds become

available to the FI just as it is called upon to pay out the funds. But to achieve this

match is extremely difficult due to the different time preferences between

borrowing and lending customers (Nazneen, 2007). The sample Asset/Liability

maturity mismatch schedule shown below represents a simple way to look at the

maturity profile of a bank:

Maturity Bucket

Assets (in millions)

Liabilities (in millions)

Liquidity GAP

Cumulative Gap (CGAP) (in millions)

ID 0 0 0 0 1D - 3M 760 1060 -300 -300 3M - 6M 1200 3400 -2200 -2500 6M - 1Yr 1700 2850 -1150 -3650 1Yr - 5Yr 6100 2500 3600 -50

> 5Yr 9250 8500 1750 700

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If we analyze the bank above for a one year period, we can see that the assets due

over the period are insufficient to cover liabilities which are coming due. A negative

CGAP of $ 3,650 million for the one year period indicates that the bank is going to

face problems in funding its obligations. Therefore, the asset/liability committee must

take necessary steps to prevent this mismatch. However, the position improved

beyond 5 years, as “over the 5 Year Bucket” shows a positive CGAP of $700

million.

2.2

Liquidity Ratio:

The Liquidity Ratio measures the extent to which a bank can quickly liquidate its

assets, and pay the creditors who are seeking payment. One way to obtain this ratio

is to divide the Liquid Assets of a bank by its Core Deposits. The higher the ratio, the

better the liquidity position of a bank (Carapeto, 2010) Consider the Balance Sheet

of XYZ Bank below:

Assets $m Liabilities and Equity $m Cash in Hand 250 Current (Demand) Deposits 7000 Trading Securities (T-Notes) 1000 Savings Deposits 4300 Investment Securities 750 Time Deposits 9650 Loans to Banks 5400 Accounts Payable 400 Loans to Customers 15350 Short-term Borrowings 200 Other Assets 200 Shareholders’ Equity 1400 Total Assets 22950 Total Liabilities and Equity 22950

The Liquid Assets include Cash and Trading (Short-term) Securities which add up to

$1,250 million. The Core Deposits include Current and Savings Deposits which add

up to $ 11,300 million. Hence by using the values for Liquid Assets and Total

Deposits, we obtain a Liquidity Ratio of 11.06% which means is a risky bank,

because its liquid assets are only 11.06% of its Core Deposits. However, an

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alternative way to obtain the ratio is to divide Short-term Securities by Total

Deposits. We usually want this ratio to be high.

2.3

Net Loans to Total Assets Ratio:

This ratio is obtained by dividing Net Loans by Total Assets. It indicates what

proportion of the bank’s total assets is tied up in loans, which are illiquid assets for a

bank. The lower the ratio, the better the liquidity position of a Financial Intermediary

(Carapeto, 2010). Using the balance sheet of XYZ Bank above, we can determine

the value for this ratio. Assuming the loans to be net of Reserves for Loan losses,

we get Net Loans as $20,750 million. Thus by using the figures for Net Loans and

Total Assets we obtain a ratio of 90.41%. This indicates that the liquidity position of

XYZ is not good as 90.41% of its total assets are tied up in loans. We are usually

looking for a low Net Assets to Total Assets ratio.

2.4

Loans to Deposits (LTD) Ratio:

A bank obtains this ratio by Dividing Total Loans (Non-liquid Assets) by Total

Deposits (Liquid Liabilities), and is a good measure of liquidity risk. It is also one of

the Financial Soundness Indicator. The higher this ratio, the worse would be the

liquidity position. A LTD ratio of 99.04% for XYZ Bank indicates that XYZ is relying

heavily on its deposits, and it may also have difficulty in fulfilling the unexpected fund

requirements (Investopedia, 2010). Hence, we try for a low LTD ratio.

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3. Managing Liquidity Risk:

The tumult in the global financial markets and the credit crunch that started affecting

global operations has given financial institution’s risk management great lessons to

learn and to deal with liquidity risks in the future. Just how liquidity risk identification and

measurement is crucial, managing and controlling the determined risk holds equal

importance. Liquidity risk management assists a bank in reducing costs associated with

liquidity shortage problems. Vital rudiments of sound risk management include the

following:

3.1

Effectual corporate governance under supervision of Board of Directors should be

implemented. The board of directors are held responsible for liquidity risk than an

institution assumes. Therefore, Board should ensure risk tolerance of the institution

is recognized. BOD should also ensure that they establish lines of authority and give

responsibility to them for controlling liquidity risk while simultaneously understanding

the risk profiles of subsidiaries and affiliates as appropriate (National Credit Union

Administration, 2010).

Corporate Governance:

3.2

Liquidity strategy of a bank of a financial institution will set out the approach that is

being adopted towards dealing with liquidity. The ultimate aim of the strategy will be

to tackle bank’s objective of defending the financial strength as well as baring

stressful, critical events that occur in the markets.

Strategies & Policies:

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An Institution’s liquidity strategy will articulate the policies on specific features of

management of liquidity. These include characteristics such as composition of

assets and liabilities, the approach adopted to manage liquidity in different

currencies and countries, the degree of reliance that the institution places on certain

financial instruments and the marketability of assets. A strategy should also be

formulated and agreed upon by management to deal with temporary and long term

liquidity concerns. It is fundamental that the strategies for managing liquidity risk

should be conversed across the organization. All the divisions of the financial

institution whose activities effect liquidity of the institution should be aware of the

strategy and shall only operate under the standard policies and procedures of the

institution (Caymand Islands Monetary Authority, n, d).

One example of a strategy that a bank can adopted in diversification in sources of

funds. A general liquidity management and control practice is to restrict attention to a

particular funding source such as only wholesale funding or only retail funding. A

combination of two will provide bank with sufficient diversity to ensure that funds are

available at the right maturities at reasonable costs (Bank for International

Settlements, 2008).

3.3

Board of Directors and senior management should determine and set limits of risk

which is acceptable for the financial institution. These limits should be set based on

the strategies, past experiences, nature of the transactions that occur etc. The two

most employed methods to determine risk limits are:

Determining Risk Limits:

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(a) Dynamic Risk Limits: This determines the maximum level of cash flow mismatch

occurring at a specific period of time. An example could be ratio of cumulative net

funding requirement to total liabilities for the following day, week or month.

(b) Static Risk Limits: On the other hand, static risk limits determine ratio of minimal

level of liquid assets to short term liabilities.

Minimum risk limits that should be formulated in the policies could be for example

Loan to deposit ratio (discussed above) should not exceed 70% of total deposits

excluding borrowings and liabilities (Baker et al, 2003).

3.4

An adequate system of internal controls is crucial to the overall risk management

process. An essential element of internal control system comprises of regular

independent review and assessment of effectiveness of the current system in pace

and if necessary appropriate revisions or development must be made. When the

results of these are presented to management and supervisory authorities, they will

implement in strategies and policies and to other important variables that need

necessary adjustments (Caymand Islands Monetary Authority, n, d).

Internal control:

3.5

In order to manage liquidity risks, it is imperative for the banks and other financial

institution’s to comprehend intraday cash flows in alignment with customer’s

commotion to assist them understand the periods when funding is needed the most

and when the typical variation in this need is likely to occur. Customer’s peak credit

demands can be smoothened via imposition of overdraft limits on the customers. For

Active management of intraday liquidity positions:

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day to day management of liquidity, a strategy should be formulated and

communicated throughout the institution (Federal Financial Institutions Examination

Council, n, d).

3.6

Stress tests and scenario analysis hold immense importance in liquidity

management. Stress test or scenario testing as it is termed will identify the exposure

of a firm to liquidity risk. Regulators also place emphasis on well planned and

executed scenario testing as liquidity management tool and active involvement of

management in doing so (Barfield et al).

Scenario/Stress testing:

Laying out “what if” scenarios is like identifying the behavior of cash flows of a bank

under different conditions. The testing should be done under 2 or more scenarios

depending on the complexity and volatility of conditions. First scenario is likely to be

on-going business environment scenario while second could be the company

specific crisis taking into account both external and internal factors (Central Bank of

Barbados, 2008). Banks should utilize the results of the stress tests in order to

identify the adjustments needed to its liquidity risk management policies and

strategies and for devising effective contingency funding plans (Fiscal Policy

Research Institute, 2010).

3.7

Contingency funding plans are devised to organize banks’ strategies for covenanting

with stress scenarios. These plans will assist bank identify potential sources of funds

available to cover the shortfalls that may arise in adverse conditions. In other words,

Contingency funding planning:

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precise guidance should be provided as to understanding the relationship between

scenario testing and CFP’s and what warnings does it give to management, early

indicators, the internal and external communication of the strategies and willingness

to execute plans when needed (Institution of International Finance, 2007).

The ability of a bank’s ability to survive short and long term liquidity crises can

largely be influenced by competence of contingency plan in place. An effective

contingency plan should have following components:

(1) Persistent flow of information to senior management in a timely manner and

procedures in place.

(2) Clear understanding of who within management is to assume responsibility if a

liquidity crisis occurs.

(3) Plan in action for making amendments to composition of assets and liabilities.

(4) Back-up sources of funding should be identified including in identification of

primary and secondary sources of liquidity.

(5) Categorization of bank customers (borrowers) and other trading partners in terms

of their importance to the financial institution (Central Bank of Barbados, 2008).

3.8

As part of the reporting requirements, financial institution should report the following

to Monetary Authority:

Reporting Requirements:

(1) Submit in written a copy of their liquidity management policy.

(2) Submit on quarterly basis the attached regulatory return – Maturity Gap Analysis.

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(3) Advise about current or future liquidity of bank and the strategies that have been

devised by management to address the concerns.

These reporting requirements differ from country to country however they are crucial

to liquidity risk management for any bank or financial institution (Caymand Islands

Monetary Authority).

4. Conclusion: Despite the innumerable literature and principles on measurement and management of

liquidity risk, a lot has gone wrong in financial systems that led to the financial crisis

beginning 2007-2008. According to an article, four crucial lessons learnt from current

crisis that should assist is avoiding future problems need to be understood. Firstly, there

needs to be better understanding about the sources of liquidity risk especially under

stressed conditions. Secondly, effective contingency funding plans need to be devised

by banks. Moreover, via better disclosure of liquidity risk management policy, banks

should sustain enhanced performance of the market and stricter market regulation.

Lastly, it is important that liquidity risk management is taken to higher standards in order

to avoid costs associated with bank failure (Jenkinson, 2008).

A liquidity risk management forum was held in 2009 in UAE where opinions of experts

from different banks and institutions had participated. Dr. Saidi in the forum pointed out

that there is a need for new liquidity management norms because despite the strict

liquidity norms set by Basel and domestic regulations, current crisis spiraled around the

banking systems. He also pointed that banks need to have more effective risk

management policies in place which should be transparent to management. Joachim

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Block Group Chief Risk Officer of Emirates NBD added his opinion and advised that

having a more extensive liquidity policy is crucial to strong governance (Khaleej Times,

2009).

It is therefore evident that well formulated strategies, policies and practices needs to be

implemented along with some regulations from Central Bank to effective manage

liquidity risk.

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5. References:

• Baker & McKenzie (2003) “Audit Manual for Liquidity Risk”, Bank of Thailand [online], Available: http://www.bot.or.th/English/FinancialInstitutions/FI_Corner/RiskMgt_Manual/DocLib_DocumentForDownload/RiskManagementExaminationManaul_05_LiquidityRisk.pdf [Accessed 30th November, 2010].

• Bank for International Settlements (2008) “Principles for Sound Liquidity Risk

Management and Supervision”, Basel Committee on Banking Supervision [online], Available: http://www.bis.org/publ/bcbs144.pdf [Accessed 30th November, 2010].

• Barfield, R. & Venkat, S. (n,d) “Liquidity Risk Management”, PriceWaterHouseCoopers [online], Available: http://www.pwc.com/en_GX/gx/banking-capital-markets/pdf/liquidity.pdf [Accessed 28th November, 2010].

• Carapeto, M. (2010), ‘Distress Resolution strategies in the Banking Sector: Implications for Global Financial Crisis’ [online] Vol. 11, pp. 12, Available: Emerald [Accessed 25th November, 2010].

• Caymand Islands Monetary Authority (n,d) “Statement of Guidance – Liquidity Risk Management” [online], Available: http://www.cimoney.com.ky/default.aspx?id=0&ItemID [Accessed 26th November, 2010].

• Central Bank of Barbados (2008) “Liquidity Risk Management Guideline” [online], Available: http://www.centralbank.org.bb/WEBCBB.nsf/vwPublications/989BD4BF1C97098B0425741A00425EB3/$FILE/Liquidity_Risk_Management_Guideline.pdf [Accessed 28th November, 2010].

• Ernst and Young (2009) “Measuring and managing liquidity risk” [online], Available: http://www.ey.com/Publication/vwLUAssets/liquity-risk-brochure-1109/$FILE/liquidity-risk-brochure-1109.pdf [Accessed 28th November, 2010].

• Federal Financial Institutions Examination Council (n, d.) “Liquidity Risk” [online], Available: http://www.ffiec.gov/ffiecinfobase/booklets/wholesale/13.html [Accessed 26th November, 2010].

• Fiscal Policy Research Institute (2010) “Regulation and Supervision for Sound Liquidity Risk Management for Banks”, The ASEAN Secretariat [online], Available: http://www.aseansec.org/documents/ASEAN+3RG/0910/FR/17b.pdf [Accessed 30th November, 2010].

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• Hogan, W. (2004), Management of Financial Institutions, John Willey and Sons, Australia, pp. 191.

• Institution of International Finance (2007) “Principles of Liquidity Risk Management” [online], Available: http://www.afgap.org/documents/Divers/LiquidityPaper.pdf [Accessed 29th November, 2010].

• Investopedia (2010) “Loan to Deposit Ratio – LTD” [online], Available: http://www.investopedia.com/terms/l/loan-to-deposit-ratio.asp [Accessed 30th November, 2010].

• Jenkinson, N. (2008) “Strengthening Regimes for Controlling Liquidity Risk: Some Lesson from the Recent Turmoil”, Bank of England [online], Available: http://www.bankofengland.co.uk/publications/speeches/2008/speech345.pdf [Accessed 20th November, 2010].

• Khaleej Times (2009) “Managing Liquidity Risk Crucial for UAE Banks” [online], Available: http://www.khaleejtimes.com/darticlen.asp?section=business&xfile=data/business/2009/April/business_April979.xml [Accessed 21st November, 2010].

• Nazneen (2007) “How to measure and manage liquidity risk, interest rate risk and foreign exchange risk using GAP Analysis” Bangladesh Bank [online], Available: http://www.bangladesh-bank.org/mediaroom/circulars/brpd/gumeasurebrpd04.pdf [Accessed 28th November, 2010].

• National Credit Union Administration (2010) “Interagency Policy Statement on Funding and Liquidity Risk Management”, Federal Reserve [online], Available: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20100317.pdf [Accessed 30th November, 2010].

• Standard Chartered Annual Report (2008) “Managing risk responsibly”, Standard Chartered [online], Available: http://www.standardchartered.com/annual-report-08/en/financial_risk_review/risk_review.html#liquidity_risk [Accessed 30th November, 2010].