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Liquidity Risk Management

Introduction

‘Liquidity’ in banking is defined as the ability to meet anticipated and contingent cash need. These cash need occurs when there are withdrawal of deposits, liability maturities and loan disbursals. The requirement is met by increasing deposits and borrowings, loan repayments, investment maturities and the sale of assets.

The need for liquidity arises from,

• Need to replace the out flowing funds that results in funding risk.
• Need to compensate for an expected inflow that has not occurred giving rise to time risk.
• Need to meet contingent liabilities when it becomes due.
• Need to undertake new transactions when required giving rise to call risk.

Inadequate liquidity can lead to liquidity insolvency of the bank without being capital insolvent (negative net worth). Excessive liquidity also negatively affects a bank as it results in low asset yields and poor earnings.

There are a few methods by which a bank can gain liquidity when the need arises

• Central Bank: An important source of short-term liquidity in domestic currency is the central bank. Certain assets can be rediscounted or used as collateral for short-term loans.
• Collateralized Lending Facility: Here, the scheduled commercial banks are provided refinance up to 0.25 percent f their fortnightly average outstanding aggregate deposits. Such refinance is available for two weeks at the Bank Rate. The amount drawn under CLF will have to be paid off within 90 days.
• Foreign Currencies: With foreign currency, the central bank cannot be depended on for liquidity. In a system of floating exchange rates, central banks are not obliged to exchange foreign currencies for domestic currency at fixed rates or as required by banks. Hence the liquidity required by banks have to be raised through dealings in financial markets and from lines of credit established with other banks.