In the business of banking, there will be inflows of resources (i) deposits under various schemes, (ii) borrowings, (iii) raising capital/bonds and so on as part of resource mobilization.
The same funds are required to be deployed in (i) loans and advances under prescribed schemes, (ii) comply with the statutory liquidity ratios prescribed by the Central Bank of the country, (iii) invest surplus funds in market instruments to earn arbitrage and can go for (iv) interbank lending etc., as part of deployment strategy.
In the process, an interesting and noteworthy feature is that banks are required to undertake maturity transformation and tenor transformation. Resources flow into banks at different points of time for different time periods according to the needs and choice of customers.
Similarly, banks have to lend to borrowers for varied time periods depending upon the products, interest rates and needs of borrowers. Banks, practically do not have control on time period and size of inflow of deposits and outflow of advances. They all happen at the sole choice of users of the banking system. Banks can chose a time period, access debt funds at ongoing interest rates and can decide the size of amount of funds it can source other than from depositors.
Banks also get float funds due to pipeline transmission of funds through remittances either from abroad or from domestic markets as part of banking operations. In managing dynamics of resource mobilization and deployment, there will be mismatch in time and size of fund inflows/outflows. Such mismatch gives rise to liquidity risk in banks which needs to be managed at minimum costs. Banks should always remain liquid to meet its payment obligations.
Liquidity will refer to the unhindered cash flows among the market players in financial markets with particular focus on the flows among the central bank, commercial banks and markets.
Therefore, liquidity risk is simply a likely instance of inability of banks to raise cash when needed to honor their commitments. Or raising of such cash for bank in need becomes exorbitantly costly leading to loss to the bank. Liquidity risk may also arise out of lack of marketability of securities held by the banks either due to market crash or due to illiquid state of the market.
Thus the bank is unable to convert an asset into cash thereby running into a possible default in honoring its own commitments.
The financial crisis of 2008, once again highlighted the importance of availability of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at normal market rates of interest. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time exacerbating liquidity risk for banks. Thus the banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and help banks mitigate liquidity risk.
Cost linkage with liquidity
Banks in its internal resource management policy strives to build a portfolio of assets and liabilities over a period of time in a way that mismatches are kept at low and manageable levels. It requires lot of research support and data analytics to arrive at customer preferences and price the products so as to modulate the inflows to reduce mismatches as far as possible.
The asset and liability products need to be priced and cost of meeting liquidity mismatches have to be built into them so that liquidity can be matched either by borrowing funds to meet shortfalls or lend in the markets with surplus funds, if any. The repercussions of liquidity have deep connections with costs of overcoming liquidity shortfall for banks.
Therefore, banks can meet liquidity but the costs can be, at times prohibitive which becomes counterproductive. While funding gap between assets and liabilities cannot be avoided but a sustained proactive policy of resource mobilization and continuous engagements with line management can improve deployment and can eventually reduce costs.
Tools of liquidity risk management
In order to help banking system to overcome liquidity risk, Basel Committee has strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives.
The first objective is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for at least a month. The Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective.
The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The Net Stable Funding Ratio (NSFR) has a time horizon of one year and has been developed to provide a sustainable maturity structure of assets
The Basel Committee focus
In its Basel III framework, Bank for International Settlement (BIS) called for maintaining liquid assets sufficient to meet the organizational liquidity needs in terms of its size and mismatches stemming out of its normal business operations.
In line with Basel Committee recommendations, like many Central Banks, the Central Bank of Sri Lanka too guided its banks to maintain Liquidity Coverage Ratio (LCR) and put liquidity risk monitoring tools to manage liquidity risk more effectively.
However, such monitoring shall be only an additional minimum requirement and every bank shall also monitor the liquidity position further relative to its size and nature of the business operations. Banks should develop a matrix to identify contractual maturity mismatch profile, i.e., the gaps between the contractual inflows and outflows of liquidity for defined time bands to assess the potential liquidity needs.
Further the banks should develop a yet another matrix to mitigate the funding concentration risk that may arise from significant counterparties, products/instruments and currencies.
This will help in mitigating liquidity risks. It will also be important to develop a tool to monitor LCR in each significant currency on an ongoing basis in order to capture potential currency mismatches. Significant currencies shall be determined internally based on the bank’s volume of transactions in such currencies and its ability to raise funds in foreign currency markets.
As banks get into more sophisticated products and services imbibing international financial markets, liquidity inflows and outflows and its timing will be more uncertain and intricate.
In such developments, banks will have to be cautious and put systemic controls in place to ensure that they manage liquidity well and can develop resilience against the usual volatility and remain prepared for contingencies of illiquidity
It is necessary for banks to disseminate and share information on importance of sensitization towards nuances of liquidity management to line management to enable them to regulate fund flows to mitigate such emerging headwinds of liquidity risks.
(The author is Director, National Institute of Banking Studies and Corporate Management – NIBSCOM. The views are his own)