Liquidity Risk Management This risk arises due to

Liquidity Risk Management • This risk arises due to mismatch of assets and liabilities • Short term borrowing and long term lending results into this risk • Short term borrowing at lower cost and long term lending at a higher yield • Profit is ensured but liquidity risk arises • Banks need to maintain short as well as long term liquidity

Approaches to Liquidity Risk Mgt. • Fundamental Approach – To ensure long term liquidity • Technical Approach – To ensure short term liquidity

Fundamental Approach • To reduce long term liquidity risk • Adjustment of long term maturity of assets and liabilities • Diversification and broadening of sources and uses of funds • This is done by either liability creation or by assets liquidation

Assets Management • Holding near cash assets • Depending on Primary or Secondary reserve • Primary reserve – CRR • Secondary reserve – Marketable securities held for liquidity purpose

Considerations while assets management • If funds are put up in Govt. security – Liquidity, safety are higher and yield is moderate • If funds are put up in corporate instruments – Return is higher but liquidity and safety are lower

Liability Management • Sources of fund is focused • Funds are borrowed as per need • Cost of borrowing and maturity of instruments is important

Considerations while Liability Management • Interest rate fluctuation may increase cost and thereby risk • Sources and time period of borrowings to be taken into account

Applicability • Depends upon – Size of the bank – Nature of operation of bank • For small size bank – Assets management is better option – Major portion is retail deposit. Liquidity requirement is relatively low • For large size bank – Liability Management is better option

Technical Approach • Short term liquidity management • Linked to cash flow arising due to operational transaction • Bank should know its cash requirement and cash flow to ensure safe level of liquidity • For this purpose there are two approaches – Working Fund Approach – Cash Flow Approach

Working Fund Approach • It focus on actual cash position on factual data • Working Funds includes – Owned Funds – Deposits – Float Funds

Owned Funds • Liquidity for owned funds is nil

Deposits • Liquidity requirement for deposits depends upon maturity profile of deposits • Volatile funds – Current a/c, short term deposits – 100 % liquidity is required • Vulnerable funds – Saving deposits – Less than 100 % liquidity is required • Stable funds – Term deposits – Least liquidity is required

Float Funds • Funds are in transit • DD, BC, MT, TC etc • 100 % liquidity is required

Assessing liquidity position on the basis of working fund • Decide average cash balance to be maintained as a % of working fund • Decide range of acceptable variance • If average balance is within this range liquidity is ensured • If not corrective action is required – Either deploying surplus fund – Or borrowing to meet the deficit

Cash Flow Approach • It takes into account potential increase or decrease in deposits / lending • Trends can be established on the basis of historical data • Planning horizon is to be decided

Basic steps in Cash Flow Approach • Estimate anticipated change in deposit • Estimate cash inflow by loan recovery • Estimate cash outflow by deposit withdrawal and loans • Estimate liquidity need over the planning horizon • Accurate forecasting & good data collection network is required for the success of this approach

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Exchange Risk Management • It is the risk that arises due to fluctuation in exchange rate • Sale and purchase of foreign currency involves risk due to change in exchange rate • Exchange rate changes due to change in demand supply of foreign currency

Foreign exchange exposure • Foreign exchange exposure is the sensitivity of change in value of assets or liabilities or operating income to unanticipated changes in exchange rate • Exposure is the absolute amount of money that is at risk • Firm can set target for the level of exposure that they will be able to sustain

Types of exposure • Transaction exposure • Translation exposure

Transaction exposure • Risk due to change in exchange rate at the time of execution of transaction and at the time of settlement • Transaction exposure is because of • Import / export • Dividend paid / received in foreign currency • Loan repayment made in foreign currency

Translation Exposure • This is relating to valuation of assets and liabilities and it arises while preparing consolidated balance sheet of a bank having branches, subsidiaries abroad • Foreign currency assets and liabilities are valued at prevailing exchange rate • Possibility of loss or gain • Guidelines for valuation are issued by FEDAI and ICAI

Managing Exposure • Internal Technique – Netting – Leading and Lagging – Invoicing • External Technique – Forward Contract – Currency Future – Currency option – Currency swap

Netting • Assets in foreign currency is used to pay liability • No need for conversion • Simultaneous occurrence of inflow and outflow in same currency and same amount is pre-condition • EEFC account facility can be used

Leading and Lagging • Leading means advancing cash flow than due date • Lagging means delaying cash flow beyond due date • Conversion of currency can be avoided • Consent of the counterparty is required

Invoicing • By making invoice in domestic currency conversion and exchange risk can be avoided • Here the risk is transferred to counterparty

Forward Contract • Agreement to buy or sell foreign currency for – Pre-determined amount – Pre-determined rate – Pre-determined date • Counter party is a banker • Bank normally covers the position • Actual cash flow occurs at delivery

Currency Future • Similar to forward contract Difference is • Here there is secondary market • Future are traded on exchange • Operations as per rules, regulation and guidelines issued by exchange • Margin is required to be deposited with exchange

Currency Option • Buyer of an option has a right but not an obligation to buy or sell foreign currency • Traded on exchange • Standard size, maturity date • Guidelines are issued by exchange

Currency Swap • It is useful to change composition of foreign currency assets and liabilities • Used to exchange excess of one currency with other