How to Mitigate Liquidity Risk Management in Banks

What is liquidity in banks? 

Liquidity can be termed as the banks’ capacity to fund the increase in their assets and meet the expected or unexpected financial obligations when they are due. Moreover, banks should have the ability to fulfill those financial obligations at a reasonable cost, and without any unacceptable losses.

Simply put, “Liquidity in banks” refers to banks’ capacity to raise rapidly cash at a reasonable cost without suffering catastrophic losses.

What is liquidity risk and liquidity risk management in banks?

Liquidity risk arises when the banks are unable to meet their financial obligations, as and when they are due. However, such a liquidity risk can adversely affect the bank’s financial condition and reputation. Such liquidity risks arise when the investments made by banks are not quickly saleable in the market to minimize the loss. Thus, it is imperative to manage liquidity risk optimally and effectively. Thus, liquidity risk management plays an important role of managing liquidity in banks.

Currently, due to the COVID-19 pandemic, the Liquidity Coverage Ratio (LCR) has been reduced to 80% for Indian banks as per the recent RBI guidelines. However, it will be increased to 100% from April 1, 2021.

What are the sources of liquidity risk in banks?

There are two types of liquidity risks. Cash flow or funding liquidity risk and asset/product or market liquidity risk.

Cash flow or funding liquidity risk is when banks are unable to pay their outstanding loans or financial obligations as and when they are due. Whereas, when the banks are unable to sell their assets or investments on time, at a required price, it is termed as market or asset liquidity risk. 

Poor management of funds and assets is how both the risks arise. However, if the banks manage their liquidity resources, viz. deposits, short-term and long-term liquid assets, e.g. treasury bills marketable equity and debt securities, ETFs, land, real estate investments, etc. then, the liquidity risk is low. Mismanagement of short and long-term liquid assets results in high liquidity risk for banks. That is the reason why RBI mandates the banks to maintain all their ratios and prepare reports quarterly of consisting of all such details. 

Sources of liquidity risks are as follows:

These listed shows that the impact of liquidity risk on banks is very high. Hence, it is deemed necessary that liquidity risk management in banks should be appropriately done. If not, the banks and gradually the banking system will collapse. This would result in the collapse of the entire economy or reduction in the value of the currency and various other domino effects would take place.

This brings us to our next discussion as to what best practices should be followed by banks for Liquidity Risk Management

4 best practices for Liquidity Risk Management by banks

The aim of liquidity risk management is to optimize costs, generate revenues, prevent bankruptcy due to credit risks and keep the banks afloat. Listed are 4 best practices for Liquidity Risk Management by banks to prevent bankruptcy and keep a check on banks’ operations:

1. Identifying liquidity risks early on

For banks, even if a single branch is under the threat of having liquidity risk, it would have system-wide repercussions throughout the bank. To avoid such circumstances, banks should rigorously follow the process of identifying, forecast and measuring the liquidity risks. This can be done with the help of a framework that can project off-balance sheet liabilities and assets. This framework should also help in projecting future cash flows from assets, to avoid liquidity risk. 

Such projections can be done by experts who are capable of conducting a risk analysis for extreme hypothetical situations. Additionally, banks should also maintain a backup of reliable liquid assets, which can be liquefied if the need arises.

2. Monitoring and controlling liquidity on a regular basis

Post identification and forecast of liquidity risks, banks should be able to monitor and control their funding needs. Apart from compliances required by the RBI, banks should also monitor their exposure to any sort of risks created due to funding large entities or businesses and limit the transferability of liquid assets. Banks should appoint legal entities for such checks and audits, to forecast and account for such risks. Also, the banks’ liquidity monitoring and risk tools should consist of the following metrics:

• Maintenance of all the relevant regulatory ratios as deemed by the RBI
• Liquidity indicators that are business-specific, and
• Projecting cash flows in advance

3. Conducting scheduled stress tests

In order to keep the bank afloat, and to anticipate liquidity shortfalls, banks should regularly conduct financial stress tests. These tests should include short and long-term scenarios that are extreme and can help identify and forecast the internal or external sources of liquidity strain. Such scenarios should also help banks in ensuring that all the exposures should align with the established levels of liquidity risk tolerance. Tests should include the following scenarios:

• Strains that are institution-specific
• Stress scenarios of individual or specific variables that are market-wide
• Stress scenarios of multiple variables that are market-wide

4. Creating a backup or contingency plan

Banks should adjust their liquidity risk tolerance levels using these stress test results. Accordingly, they should design strategies to develop a formal backup funding plan that states what should be done to overcome the liquidity shortfalls during emergencies. A robust contingency plan should include the following:

• Outlines to manage various stress environment scenarios
• Clear delegation of responsibilities 
• Establishing escalation procedures for emergencies or otherwise
• Regular forecasting, testing, and updates of bank’s working status and other related risks

Concluding thoughts

Banks need to prevent liquidity disasters and to do that, they need to have a clear forecast and projection of their liabilities, assets, and risks faced during the daily operations. Moreover, in order to minimize the liquidity risks, banks need to function efficiently, make decisions that are forward-looking, and in benefit of the management as well as its customers.