Liquidity plays a critical role in the smooth operations of banks and failure to adhere to effective liquidity risk management can lead to insolvency and bankruptcy.
This will have systemic negative spill-over effects on the wider economy and to some extent globally depending on how the business is funded and on its supply management chain.
A case in point is the 2007-08 financial crisis where many banks and companies went bankrupt due to sudden evaporation of liquidity and dislocation of the credit markets.
Liquidity is the ability of the business to meet both its short-term and long-term contractual obligations when they fall due.
This includes meeting collateral margin requirements, off-balance sheet and non-funded commitments when specified event triggers occurs.
Early warning signs of liquidity stress include but are not limited to the following:
- Rating agency credit watches for potential downgrades on debt issues
- Rising funding costs in an otherwise stable market
- Reduction and or elimination of committed lines of credit by counterparties
- Widening of spreads on debt, credit default swaps and stock price declines
- Difficulty in raising debt in the markets
- Negative press coverage gives rise to reputation risk.
- Margin calls.
Banks Liquidity management
Bank sources of liquidity are:
- Retail customer deposits
- Wholesale deposits
- Market deposits
- Securitization
- Asset sales
- Borrowing from central bank and counterparties
- Committed lines of credit
Bank liquidity management policy is documented and approved by the Board of Directors. All staff should read and understand this policy. The liquidity risk management part is done through the Asset and Liability Committee (ALCO) which manages the assets and liabilities to ensure the bank earns adequate returns on its capital.
Banks employ procedures and processes and standards to cushion themselves from the effects of liquidity stress. Balance sheet structure and composition of assets and liabilities give rise to liquidity imbalances which can impair the adequacy of capital to act as a buffer against adverse market conditions and in a normal market environment.
Sensitivity of assets and liabilities to macro-economic factors should be considered as this can also be a source of liquidity strain on the balance sheet. The responsiveness of assets and liabilities creates liquidity gaps that need to be funded or allocated appropriately.
Banks by their nature operate a highly leveraged business hence the regulatory control and continuous onsite and offsite supervision by the central banks to mitigate systemic risk and financial instability in the economy.
Banks are required to adhere to Basel Committee of Banking Supervision (BCBS) standards to have access to the international market.
The current Basel 111 standards stipulate the best way to manage liquidity risk through the Liquidity coverage ratio (LCR) and Net Stable Funding Ratio (NSFR). Stress tests are done on the bank portfolios (on and off-balance sheet) against plausible worst-case scenarios to find out the adequacy of capital provision to meet adverse stress conditions. If the capital is insufficient to meet the stress shortfalls the bank has to restructure its assets and liabilities or raise more capital. Current liabilities maturity will be extended while assets maturity will be shortened. The capital raising will depend on the bank`s position in the markets and the riskiness of its portfolio. The bank will choose the cost-effective alternative.
In addition, the bank has to keep high-quality liquid assets that are easily convertible into cash at a reasonable price to cater for unexpected bank-specific events and or external shocks. These high-quality liquid assets should be unencumbered.
Diversification of funding sources and tenor should be of paramount importance.
Contingency funding plans and business resumption plans should be tested and assumptions updated depending on conditions in the market.
Bank supervision through central banks plays a critical role in containing wayward behaviour by banks.
The emergence of innovative blockchain technology through its decentralization role and tokenization of assets is likely to change the banking landscape in the near future and this also calls for innovative ways of managing liquidity.
The non-bank financial companies are also dispersing loans on a large scale and this is shifting liquidity risks into this sector.
Cybersecurity risks are a cause for concern as far as liquidity risk and management is concerned as they disrupt set plans and processes to contain it.
Finally, adherence to ESG (Environment, social and governance) creates movement towards sustainable financing towards climate and this is a new source of funding albeit geared towards ESG principles.
Sources: Principles for sound liquidity risk management and supervision, September 2008, Comptroller`s Handbook, safety and soundness, liquidity version 1.00 June 2012
