Liquidity Risk Management: CAIIB Paper 2 (Module B), Unit 7

Liquidity Risk Management: CAIIB Paper 2 (Module B), Unit 7

Dear Bankers,
We all know that CAIIB exams are conducted by the Indian Institute of Banking and Finance (IIBF).  CAIIB is said to be one of the difficult courses to be cleared for the bankers. But we assure you that with the help of our “CAIIB study material”, you will definitely clear the CAIIB exam.
CAIIB exams are conducted twice in a year. Candidates should have completed JAIIB before appearing for CAIIB Exam. Here, we will provide detailed notes of every unit of the CAIIB Exam on the latest pattern of IIBF.
So, here we are providing “Unit 7: Liquidity Risk Management” of “Module B: Risk Management” from “Paper 2: Bank Financial Management (BFM)”

Liquidity Risk Management – Need & Importance

A bank is said to be solvent if it’s net worth is not negative. To put it differently, a bank is solvent if the total realizable value of its assets is more than its outside liabilities (i.e., other than its equity/owned funds). As such, at any point in time, a bank could be (i) both solvent and liquid or (ii) liquid but not solvent or (iii) solvent but not liquid or (iv) neither solvent nor liquid. The need to stay both solvent and liquid therefore, makes effective liquidity management crucial for increasing the profitability as also the long-term viability/solvency of a bank. This also highlights the importance of the need of having the best Liquidity Risk Management practices in place in Banks.

Some Key Considerations in Liquidity Risk Management include:

  • Availability of liquid assets,
  • Extent of volatility of the deposits,
  • Degree of reliance on volatile sources of funding,
  • Level of diversification of funding sources,
  • Historical trend of stability of deposits,
  • Quality of maturing assets,
  • Market reputation,
  • Availability of undrawn standbys,
  • Impact of off balance sheet exposures on the balance sheet, and
  • Contingency plans.

Some of the issues that need to be kept in view while managing liquidity include:

  • The extent of operational liquidity, reserve liquidity and contingency liquidity that are required.
  • The impact of changes in the market or economic condition on the liquidity needs.
  • The availability, accessibility and cost of liquidity.
  • The existence of early warning systems to facilitate prompt action prior to surfacing of the problem and
  • The efficacy of the processes in place to ensure successful execution of the solutions in times of need.

 Potential Liquidity Risk Drivers

The internal and external factors in banks that may potentially lead to liquidity risk problems in Banks are as under:

Internal Banking Factors External Banking Factors
 High off-balance sheet exposures Very sensitive financial markets depositors.
The banks rely heavily on the short-term corporate deposits External and internal economic shocks.
A negative gap (liability is more than the asset) in the maturity dates of assets and liabilities. Low/slow economic performances.
The banks’ rapid asset expansions exceed the available funds on the liability side. Decreasing depositors’ trust on the banking sector
Concentration of deposits in the short term Tenor Non-economic factors
Less allocation in the liquid government instruments. Sudden and massive liquidity withdrawals from depositors.
Fewer placements of funds in long-term deposits. Unplanned termination of government deposits.

 

Types of Liquidity Risk

Banks face the following types of liquidity risk:

  • Funding Liquidity Risk – the risk that a bank will not be able to meet efficiently the expected and unexpected current and future cash flows and collateral needs without affecting either its daily operations or its financial condition.
  • Market liquidity Risk – the risk that a bank cannot easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption.

Principles For Sound Liquidity Risk Management

After the global financial crisis, in recognition of the need for banks to improve their liquidity risk management, the Basel Committee on Banking Supervision (BCBS) published “Principles for Sound Liquidity Risk Management and Supervision” in September 2008. The broad principles for sound liquidity risk management by banks as envisaged by BCBS are as under:

BCBS’s Fundamental principle for the management and supervision of liquidity risk
Principle 1 A bank is responsible for the sound management of liquidity risk. A bank should establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to withstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources. Supervisors should assess the adequacy of both a bank’s liquidity risk management framework and its liquidity position and should take prompt action if a bank is deficient in either area in order to protect depositors and to limit potential damage to the financial system.
Governance of liquidity risk management
Principle 2

 

A bank should clearly articulate a liquidity risk tolerance that is appropriate for its business strategy and its role in the financial system.

 

Principle 3 Senior management should develop a strategy, policies and practices to manage liquidity risk in accordance with the risk tolerance and to ensure that the bank maintains sufficient liquidity. Senior management should continuously review information on the bank’s liquidity developments and report to the board of directors on a regular basis. A bank’s board of directors should review and approve the strategy, policies and practices related to the management of liquidity at least annually and ensure that senior management manages liquidity risk effectively.
Principle 4 A bank should incorporate liquidity costs, benefits and risks in the internal pricing, performance measurement and new product approval process for all significant business activities (both on- and off-balance sheet), thereby aligning the risk-taking incentives of individual business lines with the liquidity risk exposures their activities create for the bank as a whole.
Measurement and management of liquidity risk
Principle 5 A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a robust framework for comprehensively projecting cash flows arising from assets, liabilities and off-balance sheet items over an appropriate set of time horizons.
Principle 6 A bank should actively monitor and control liquidity risk exposures and funding needs within and across legal entities, business lines and currencies, taking into account legal, regulatory and operational limitations to the transferability of liquidity.
Principle 7 A bank should establish a funding strategy that provides effective diversification in the sources and tenor of funding. It should maintain an ongoing presence in its chosen funding markets and strong relationships with funds providers to promote effective diversification of funding sources. A bank should regularly gauge its capacity to raise funds quickly from each source. It should identify the main factors that affect its ability to raise funds and monitor those factors closely to ensure that estimates of fund raising capacity remain valid.
Principle 8 A bank should actively manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis under both normal and stressed conditions and thus contribute to the smooth functioning of payment and settlement systems.
Principle 9 A bank should actively manage its collateral positions, differentiating between encumbered and unencumbered assets. A bank should monitor the legal entity and physical location where collateral is held and how it may be mobilised in a timely manner.
Principle 10

 

A bank should conduct stress tests on a regular basis for a variety of short-term and protracted institution-specific and market-wide stress scenarios (individually and in combination) to identify sources of potential liquidity strain and to ensure that current exposures remain in accordance with a bank’s established liquidity risk tolerance. A bank should use stress test outcomes to adjust its liquidity risk management strategies, policies, and positions and to develop effective contingency plans.
Principle 11 A bank should have a formal contingency funding plan (CFP) that clearly sets out the strategies for addressing liquidity shortfalls in emergency situations. A CFP should outline policies to manage a range of stress environments, establish clear lines of responsibility, include clear invocation and escalation procedures and be regularly tested and updated to ensure that it is operationally robust.
Principle 12 A bank should maintain a cushion of unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios, including those that involve the loss or impairment of unsecured and typically available secured funding sources. There should be no legal, regulatory or operational impediment to using these assets to obtain funding.
Public disclosure

 

Principle 13 A bank should publicly disclose information on a regular basis that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position.

 

Governance of Liquidity Risk Management

The Reserve Bank had issued guidelines on Asset Liability Management (ALM) system, covering inter alia liquidity risk management system, in February 1999 and October 2007. Successful implementation of any risk management process has to emanate from the top management in the bank with the demonstration of its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organisational set up for liquidity risk management should be as under:

  • The Board of Directors (BOD): The BoD should have the overall responsibility for management of liquidity risk. The Board should decide the strategy, policies and procedures of the bank to manage liquidity risk in accordance with the liquidity risk tolerance/limits as detailed in paragraph 14. The risk tolerance should be clearly understood at all levels of management. The Board should also ensure that it understands the nature of the liquidity
  • The Risk Management Committee: The Risk Management Committee, which reports to the Board, consisting of Chief Executive Officer (CEO) Chairman and Managing Director (CMD) and heads of credit, market and operational risk management committee should be responsible for evaluating the overall risks faced by the bank including liquidity risk. The potential interaction of liquidity risk with other risks should also be included in the risks addressed by the risk management committee.
  • The Asset-Liability Management Committee (ALCO): The Asset-Liability Management Committee (ALCO) consisting of the bank’s top management should be responsible for ensuring adherence to the risk tolerance/limits set by the Board as well as implementing the liquidity risk management strategy of the bank in line with bank’s decided risk management objectives and risk tolerance.
  • The Asset Liability Management (ALM) Support Group: The ALM Support Group consisting of operating staff should be responsible for analysing, monitoring and reporting the liquidity risk profile to the ALCO. The group should also prepare forecasts (simulations) showing the effect of various possible changes in market conditions on the bank’s liquidity position and recommend action needed to be taken to maintain the liquidity position/adhere to bank’s internal limits.

Liquidity Risk Management Policy

  • Liquidity Risk Tolerance: Banks should have an explicit liquidity risk tolerance set by the Board of Directors. The risk tolerance should define the level of liquidity risk that the bank is willing to assume, and should reflect the bank’s financial condition and funding capacity. The tolerance should ensure that the bank manages its liquidity in normal times in such a way that it is able to withstand a prolonged period of, both institution specific and market wide stress events.
  • Strategy for Managing Liquidity Risk: The strategy for managing liquidity risk should be appropriate for the nature, scale and complexity of a bank’s activities. In formulating the strategy, banks/banking groups should take into consideration its legal structures, key business lines, the breadth and diversity of markets, products, jurisdictions in which they operate and home and host country regulatory requirements, etc. Strategies should identify primary sources of funding for meeting daily operating cash outflows, as well as expected and unexpected cash flow fluctuations.

Management of Liquidity Risk

A bank should have a sound process for identifying, measuring, monitoring and mitigating liquidity risk as enumerated below:

  • Identification: A bank should define and identify the liquidity risk to which it is exposed for each major on and off balance sheet position, including the effect of embedded options and other contingent exposures that may affect the bank’s sources and uses of funds and for all currencies in which a bank is active.
  • Measurement of Liquidity Risk: There are two simple ways of measuring liquidity; one is the stock approach and the other, flow approach. The stock approach is the first step in evaluating liquidity. Under this method, certain ratios, like liquid assets to short term total liabilities, purchased funds to total assets, core deposits to total assets, loan to deposit ratio, etc., are calculated and compared to the benchmarks that a bank has set for itself. While the stock approach helps up in looking at liquidity from one angle, it does not reveal the intrinsic liquidity profile of a bank.

Ratios In Respect Of Liquidity Risk Management

Certain critical ratios in respect of liquidity risk management and their significance for banks are given below. Banks may monitor these ratios by putting in place an internally defined limit approved by the Board for these ratios.

Sl. No. Ratio

 

Significance

 

Industry Average (in %)

 

1. (Volatile liabilities – Temporary Assets) (Earning Assets – Temporary Assets)

 

Measures the extent to which volatile money supports bank’s basic earning assets. Since the numerator represents short-term, interest sensitive funds, a high and positive number implies some risk of illiquidity.

 

40
2. Core deposits/Total Assets

 

Measures the extent to which assets are funded through stable deposit base. 50
3. (Loans + mandatory SLR + mandatory CRR + Fixed Assets)/Total Assets

 

Loans including mandatory cash reserves and statutory liquidity investments are least liquid and hence a high ratio signifies the degree of ‘illiquidity embedded in the balance sheet. 80
4. (Loans + mandatory SLR + mandatory CRR + Fixed Assets)/Core Deposits Measure the extent to which illiquid assets are financed out of core deposits.

 

150
5. Temporary Assets/Total Assets

 

Measures the extent of available liquid assets. A higher ratio could impinge on the asset utilisation of banking system in terms of opportunity cost of holding liquidity.

 

40
6. Temporary Assets/Volatile Liabilities

 

Measures the cover of liquid investments relative to volatile liabilities. A ratio of less than 1 indicates the possibility of a liquidity problem.

 

60
7. Volatile Liabilities/Total Assets

 

Measures the extent to which volatile liabilities fund the balance sheet.

 

60

 

Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year). Letters of credit – full outstanding. Component-wise CCF of other contingent credit and commitments. Swap funds (buy/sell) up to one year. Current deposits (CA) and Savings deposits (SA) i.e. (CASA) deposits reported by the hanks as payable within one year (as reported in structural liquidity statement) are included under volatile liabilities. Borrowings include from RBI, call, other institutions and refinance.

Temporary assets = Cash + Excess CRR balances with RBI + Balances with banks + Bills purchased/ discounted up to 1 year + Investments up to one year + Swap funds (sell/buy) up to one year.

Earning Assets = Total assets – (Fixed assets + Balances in current accounts with other banks + Other assets excluding leasing + Intangible assets).

Core deposits = All deposits (including CASA) above 1 year (as reported in structural liquidity statement) + net worth.

Stress Testing

Stress testing should form an integral part of the overall governance and liquidity risk management culture in banks. A bank should conduct stress tests on a regular basis for a variety of short term and protracted bank specific and market wide stress scenarios (individually and in combination). In designing liquidity stress scenarios, the nature of the bank’s business, activities and vulnerabilities should be taken into consideration so that the scenarios incorporate the major funding and market liquidity risks to which the bank is exposed.

Contingency Funding Plan

A bank should formulate a contingency funding plan (CFP) for responding to severe disruptions which might affect the bank’s ability to fund some or all of its activities in a timely manner and at a reasonable cost CFPs should prepare the bank to manage a range of scenarios of severe liquidity stress that include both bank specific and market-wide stress and should be commensurate with a bank’s complexity, risk profile, scope of operations.

Overseas Operations of The Indian Banks’ Branches And Subsidiaries And Branches Of Foreign Banks In India

A bank’s liquidity policy and procedures should also provide detailed procedures and guidelines for their overseas branches/subsidiaries to manage their operational liquidity on an ongoing basis. Similarly, foreign banks operating in India should also be self-reliant with respect to liquidity maintenance and management.

Broad Norms In Respect Of Liquidity Management

Some of the broad norms in respect of liquidity management are as follows:

(i)Banks should not normally assume voluntary risk exposures extending beyond a period of ten years

(ii)Banks should endeavour to broaden their base of long-term resources and funding capabilities consistent with their long term assets and commitments.

(iii)The limits on maturity mismatches shall be established within the following tolerance levels (a) long term resources should not fall below 70% of long term assets; and (b) long and medium term resources together should not fall below 80% of the long and medium term assets. These controls should be undertaken currency-wise, and in respect of all such currencies which individually constitute 10% or more of a bank’s consolidated overseas balance sheet. Netting of inter-currency positions and maturity gaps is not allowed. For the purpose of these limits. Short term, medium term and long term are defined as under:

  • Short-term:             those maturing within 6 months.
  • Medium-term: those maturing in 6 months and longer but within 3 years.
  • Long-term:            those maturing in 3 years and longer.

(iv) The monitoring system should be centralised in the International Division (ID) of the bank for controlling the mismatch in asset-liability structure of the overseas sector on a consolidated basis, currency-wise. The ID of each bank may review the structural maturity mismatch position at quarterly intervals and submit the review/s to the top management of the bank.

Liquidity Across Currencies

Banks should have a measurement, monitoring and control system for liquidity positions in the major currencies in which they are active. For assessing the liquidity mismatch in foreign currencies, as far as domestic operations are concerned, banks are required to prepare Maturity and Position (MAP) statements according to the extant instructions. A bank should also undertake separate analysis of its strategy for each major currency individually by taking into account the outcome of stress testing.

Management Information System (MIS)

A bank should have a reliable MIS designed to provide timely and forward-looking information on the liquidity position of the bank and the ALM Group should place this information periodically to the Board and ALCO, both under normal and stress situations. The MIS should cover liquidity positions in all currencies in which the bank conducts its business – both on a subsidiary/branch basis (in all countries in which the bank is active) and on an aggregate group basis.

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