Liquidity risk - Free Essay Example

What is liquidity risk and how managers deal with it? COMMERCIAL AND INVESTMENT BANKING 1. Introduction Technological progress and internationalization has led to rapid innovations in financial markets and regulations. This changing environment in which banks find themselves presents great opportunities but also a wide range of risks while operating. Such risks are interest rate risk, market risk, credit risk, off-balance-sheet risk, technology and operational risk, foreign exchange risk, country or sovereign risk, liquidity risk and insolvency risk. In this paper we attempt to provide a development of liquidity risk and the way managers deal with it. For financial institutions it is an everyday activity to provide cash to their customers. Moreover, the recent economic crisis proved that banks are particularly vulnerable to liquidity problems so it is of a fundamental importance for managers to supervise, forecast and plan banks position as they are considered to be â€Å"too big to fail†. (Saunders, 1949) 2. Why is liquidity necessary? According to the Bank of International Settlements (BIS), liquidity is the ability of the bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. This means that a financial firm has immediately access to spendable funds when they are required or can raise funds by selling assets or borrowing. Liquid funds are needed from a financial institution in order to meet customers demands or in the case of banks growth. More specifically banking activities include redemption of deposits, covering of loans, pay off of previous borrowing withdrawals of money from accounts and credit request that institutions wish to keep. It is indispensable to maintain a balance between short-term assets, which are represented by loans, and short term liabilities which are represented by deposits. What is more, the time dimension is a major factor so banks should administrate time carefully as some liquidity needs are immediate. Liquidity shortfall may l ead to closing of an individual bank and consequently this can encumber the whole economy. (Rose and Hudgins, 2008) 3. Sources of liquidity But how we generate liquidity? While every financial transaction is directly related to liquidity, banks have raised several options to correspond to these demands. The most liquid asset is cash and it is used to cover withdrawals. Conversely, banks tend to keep cash levels low as cash reserves pay no interest. Thus, another important source is considered to be the sale of assets and mostly the liquidation of investment securities. The liquidation of assets pay interest revenues but in some cases may be costly for the bank or not effective, while when the asset is very liquid returns are low. In addition, customers deposits and customers loans repayment can be potential sources. (Saunders, 1949) Heffernan (1956), advocates that banks by keeping a gap between their short term deposits and long term loans can produce money (maturity mismatching). This practice, in which banks retain a fraction of their deposits in reserve and lend out the remaining, is noun as fractional reserv e lending. Borrowing funds from other banks or from the Central Bank can be another alternative element in the supply of liquidity but also the last solution for illiquidity. Obviously the appropriate level of liquidity can be achieved through managing assets and liabilities. In many cases governments insure deposits so the desirable level of liquidity is stable and banks are protected. 4. Liquidity problems Financial firms often face significant liquidity problems. This major exposure to liquidity pressures arises from several sources which can disturb the balance between liabilities and asset s of the balance sheet. On the liability side, liquidity problems can be caused when depositors withdraw large sums of money. The reasons that can trigger this removal is usual the lack of confidence in the bank or in the banking system and poor management policies. When the run starts, the value of liquidated bank assets decrease, so everyone wants to remove their deposits. The fact that customers rush to the bank to take out their money as quickly as possible to avoid losing it is known as bank run. And as a bank run escalates and more people take out their deposits, the possibility of default increases, and this encourages additional withdrawals. This can impose bankruptcy and the follow-on series of bankruptcies can induce an economic recession. This susceptibility of banks can create sys temic risk, which means problem to the entire banking system. On the side of assets of the balance sheet, liquidity troubles can be triggered by unpredicted loan default. These are mainly related with the prolong of credit lines something that is offered from banks to customers and in cases of a shortfall burdens banks position. In both aspects a financial institution, usually the central bank, intervene with remedial measures, by operating as the lender of the last resort or as a lifeboat rescue. By the term â€Å"lender of last resort† we refer to the loaning from the central bank that aims to protect depositors and evade possible extensive panic to the economy caused by the collapse of a bank. To boot, the lifeboat rescue function is when the central bank demands from another healthy bank to provide loan to the problematical one. What is more, another method that is followed by some central banks is the â€Å"too big to fail† method. The Too Big to Fail is a p hrase states that, a bank is a large and integral part of the economy that government will provide support to avert its collapse. The assistance is for large banks whereas weak ones are left to fall down and this gives all banks a motivation to enlarge their assets even though it means obtaining risky lenders. However, despite the fact that this intervention is beneficial, the money borrowed from the Central Bank or from the interbank market have a penal rate which is costly. (Heffernan, 1956) 5. What is liquidity risk? â€Å"The risk that arises from the difficulty of selling an asset. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as house)† (investorwords.com) As it is derived from the definition, liquidity risk can be distinguished in two types, asset liquidity and funding liquidity. When an asset cannot be sold by reason of market illiquidity it is considered as asset liquidity. This is the cause for making explicit liquidity reserves, widening bid or offer spread and lengthening holding period for Value at Risk (VaR) calculations. The VaR model is used to compute a banks market risk. VaR is able to estimate risk while it happens and is an important consideration when ban ks make trading or hedging decisions. On the other hand, funding liquidity is the risk that liabilities cannot be met when they fall due or can only be met at an uneconomic price. Typically, funding liquidity risk depends on the availability of the liquidity sources and the ability to satisfy the budget constraint over the respective period of time. The reasons that consider engendering liquidity risk are two: a liability-side reason and an asset-side reason. The first cause, liability-side, is brought about when a liability holder, like depositors, demand cash immediately and they withdraw their deposits. This matter can be dealed with borrowing additional funds or with selling assets. The second cause is asset-side liquidity risk and is the ability to satisfy loan commitments. As it happens with liability withdrawals, banks can meet such liquidity needs by running down its cash assets, selling off other liquidity assets or borrowing additional funds. (Wikipedia, 2009) 6. Measurement of liquidity risk While the problem of liquidity risk is becoming more pertinent to the modern banking sector, a sound process for measuring and monitoring liquidity should be applied. In order to establish a measuring frame some parameters should be taken into account. Firstly, as it is previous mentioned, various types of risks may come up with strong interaction between them. Thus, a bank should recognize all this types and the events that can create them. Secondly, it is crucial to evaluate cash inflows and outflows and liquidity value of assets to know if it has the ability to face a shortfall. A third factor that should be considered is that a bank should control its liquidity risk position for all future flows of assets and liabilities, all sources of liquidity, all currencies in which bank it is active and correspond activities. The measurement tools that a bank can use are liquidity ratios, which compute the ability of current assets to meet short term obligations. The two indicators tha t are used more repeatedly are the following: 1. Current ratio=Current assets current liabilities This ratio contrasts current assets with current liabilities so as to indicate short term solvency and debt services. 2. Quick ratio=cash and accounts receivablescurrent liabilities The acid test or quick ratio depicts the companys capability to pay back immediate commitments with cash or cash equivalents. The outcomes of these indexes rely on the financial circumstances, on each individual banks experience and on the quality of assets that are used for liquidity ratios. (bis, 2009) (Glantz, 2003) 7. Strategies for liquidity risk management It is crystal clear, from all mentioned above, that liquidity risk is one of the most important types of risk that a bank or any other company can get together. The recent turmoil in the financial system was the most appropriate and representative fact to prove that managing liquidity risk is critical for the safety and soundness of financial institutions. Liquidity risk management systems should reflect an institutions complexity, risk profile and scope of operations. (federalreserve.gov, 2009) That is why managers have developed strategies in order to deal with liquidity problems like: a) Providing liquidity from assets (assets liquidity management) b) Relying on borrowed liquidity to meet cash demands (liability management) c) Balanced (asset and liability) liquidity management (Rose and Hudgins, 2008) a) Asset Liquidity Management (or Asset Conversion) Strategies One of the oldest strategies that managers use to deal with liquidity needs is asset conversion. Banks and other depository institutions apply this strategy by storing liquidity in assets, mainly in cash and marketable securities. When is necessary these assets are converted into cash in order to cover the arising demands. But first of all we have to make clear that an asset is consider to be liquid when it has a ready market (can be converted into cash immediately), it has a stable price (the asset can be sold quickly without significant decreases in price) and it is reversible (the seller can recover his initial investment with little risk or loss) The most popular liquid assets are treasury bills, federal funds loans, certificates of deposit, municipal bonds, federal agency securities, bankers acceptances and Eurocurrency loans. Asset conversion strategy is less risky than borrowings and that is why it is usually used by small financial institutions. The opportunity cost is r egarded to be a disadvantage of this method as selling assets means loss of future profits that they might have brought if were not sold. Moreover, something that managers must take into account is the fact that assets with the least profit potential are sold first to minimize the opportunity cost. Last but not least, liquid assets have the lowest returns and this is the reason that they do not consist a profitable investment. (Rose and Hudgins, 2008) b) Borrowed Liquidity (Liability) Management Strategies This strategy is also known as purchased liquidity and involves borrowing from money market to offset liquidity need. It is used by a wide array of financial institutions as it has a series or advantages. The bank can borrow funds only when it is necessary without losing high returns. Furthermore, this method gives the right to the firm to keep its asset portfolio unchanged if it is profitable. Finally, the borrowing institution has the control of the interest rate. When a large amount of funds is needed the offered rate is high but when fewer funds are required the offer rate is lower. The volatility of interest rates makes purchased liquidity the most risky approach. (Rose and Hudgins, 2008) c) Balanced Liquidity Management Strategies This strategy combines the use of asset conversion and borrowed liquidity approaches. In balanced management expected demands for cash are covered by stored liquidity in assets while unexpected cash needs are met from near-term borrowings. There is evidence that is the best liquidity management strategy. (Rose and Hudgins, 2008) 8. Estimating liquidity needs Banks attempt to predict their liquidity needs using manifold approaches. Though these approaches may not give accurate results, they give to banks the opportunity to be able to face their needs. Liquidity estimate enables banks to have liquidity reserves including both a planned and a protective component. The planned component consists of the reserves that were predicted lately while the protective component consists of extra reserves, over those dictated by the most recent forecast. Liquidity needs estimation techniques include the sources and uses of funds approach, the structure of funds approach, the liquidity indicator approach and the market signals or discipline approach. (Rose and Hudgins, 2008) * The sources and uses of funds approach Before we analyze this method we have to make clear that in the case of a bank liquidity rises as deposits increase and loans decrease or liquidity declines when deposits decrease and loans increase. Whenever sources and uses do not m atch we have liquidity gap. When sources of liquidity exceed uses, the bank will have a positive liquidity gap (surplus). In that case the financial institution must invest this surplus of funds in assets in order to meet future cash needs. When uses exceed sources the bank has a negative liquidity gap (deficit) and it must raise means from accessible sources. There are three steps involved in the sources and uses of funds approach. 1) Forecast of loans and deposits for a specific planning period 2) Calculate the estimated change in loans and deposits for the same period 3) Estimate the net liquidity funds surplus or deficit. This can be achieved by comparing the estimate change in loans to the estimated change in deposits. (Rose and Hudgins, 2008) Managers in banks have developed some forecasting models such as the following in order to estimate the changes in loans and deposits. Estimated change in total loans for the coming period is a function of: projected growth in the econ omy,projected quarterly corporate earnings,current rate of growth in the nations money supplyprojected primeloan rate minusthe commercialpaper rate, and estimated rate of inflation Estimated change in total deposits for the coming period is a function of: projected growth in personal income in the economy,estimatedincrease inretail sales,current rate of growth in the nations money supply,projected yield on money market deposits, and estimated rate of inflation Consequently, we have estimated liquiditydeficit or surplusfor the coming period=estimated changein deposits-estimated changein loans (Rose and Hudgins, 2008) * The structure of funds approach This approach involves three steps. The first divides deposits and other funds sources into different categories depending on the probability of withdrawals. As an illustration we might divide a banks deposit and non-deposit liabilities into three categories: a) â€Å"hot money† liabilities (volatile liabilities) high interest sensitive deposits and borrowed funds that expected to be withdrawn in recent period, b) vulnerable funds- customer deposits of significant part, perhaps 25% to 30% is likely to be withdrawn in recent period, c) stable funds (core deposits/liabilities)- funds that are not likely to be withdrawn. Second step is the allocation of liquidity funds for each category of funds according to some operating rules. For example lets assume that the manager sets up a 95% liquid reserve (less any required legal reserves). For vulnerable funds he holds an unchanging proportion of their entire amount say 30%- in liquid reserves. For invariable funds the bankers place a smaller percentage- perhaps 15%- of their sum in liquid reserves. Taking into account the assumptions above the liquidity reserve behind deposit and non-deposit liabilities would be: Liability liquidity reserve= 0.95*(hot money deposits and nondeposits funds- legal reserves held) +0.30*(vulnerable deposit and non deposit funds legal reserves held) +0.15*(stable deposit and non deposit funds legal reserves held) (Rose and Hudgins, 2008) As regards to loans the bank is supposed to make good loans. By this term we mean that the customer covers the lenders loan quality principles. In that kind of customers the banker tries to sell other services as well in order to increase the lenders trust on the lending association. These extra services will also bring extra income for the bank. Management must also try to calculate approximately the maximum possible number for total loans and hold in liquid reserves the whole amount (100%) of the difference between the real amount of loans outstanding and the maximum prospective for total loans. Combining both loan and deposit liquidity requirements, the third step is to estimate the total liquidity requirement for the bank. Total liquidity requirement= deposits and nondeposits liability and loan liability liquidity= 0.95*(hot money funds - legal reserves held behind hot money deposits) +0.30*(vulnerable deposit and nondeposit funds required legal reserves) +0.15*(stable deposit and non deposit funds required legal reserves) +1.00*(potential loans outstanding- actual loans outstanding) Of course all these requirements that mentioned above are biased estimates that depend on managements experience and philosophy. (Rose and Hudgins, 2008) * Liquidity indicator approach This approach estimates liquidity needs relying on the use of experience and industry averages. It uses different liquidity indicator ratios such as: I. Cash position indicator: cash and deposits due from depository institutions à · total assets( where large quantity of cash shows strong pose for the bank) II. Liquid security indicator: government securities à · Total assets, which compares the securities that a firm owns with the whole mass of its asset portfolio (large proportion of government securities means good liquid po sition). III. Capacity ratio: Net loans and leases à · Total assets which is a negative liquidity indicator due to the fact that loans and leases are often characterized for illiquidity IV. Hot money ratio: money market (short-term) assets à · volatile liabilities= (cash and due from deposits held at other depository institutions+ holdings of short-term securities + federal funds loans + reserve repurchase agreements)/(large CDs + Eurocurrency deposits + federal funds borrowed + repurchase agreements). This indicator proves whether the bank has balanced the volatile liabilities with the money market assets that could be converted rapidly into cash. (Rose and Hudgins, 2008) * Market signal (discipline) approach This is a qualitative approach to measure liquidity requirements of banks. It is a method that centers on the obedience of the financial market position which subject banks to chain of markets tests. a)Public confidence . It is very important for individuals and institutions as well to consider that the bank is able to meet its obligations. b)Stock price behavior. There is a case where the institutions stock price may fall because investors realize that the bank face or it is about to face liquidity crisis. c)Risk premiums on CDs and other borrowings. The market is likely to impose a risk premium by higher borrowing costs if it perceives that the institution is on the road to a liquidity crisis. d)Loss sales of assets. As we mention before at the liquidity strategies, the bank may sell assets when cash needs are direct. But this sometimes leads to significant losses. The question is whether this is a exceptional invent or a common one. e)Meeting commitments to credit customers. Sometimes management rejects credit applications because of liquidity demands when otherwise these applications would be acceptable. f) Borrowings from the central bank. When the institution has borrowed funds from the Central Bank more than once and in large amount then it is something that concerns the Bank significantly. If any of these cases are presented to the bank then management needs to take a better look at its liquidity policies and make some changes if it is necessary. (Rose and Hudgins, 2008) 9. Examples of Risk Management Since liquidity risk management is a crucial issue for banks, it is usually stated on their financial reports. Going over the annual reports of two well-known banks -Alpha Bank and Millennium Bank we take a closer look at how they handle risk. Alpha Bank Alpha Bank uses a strict framework for risk management. The goal is to advance this framework with the intention of avoiding any negative impacts on the institutions financial results. Managers are active and try to keep up with the international economic environment. The improvement and supervision of the framework is under the auspices of the Board of Directors. There is also a Risk Management Committee which ensures and monitors the policies that are used. The major part of the Groups Assets is financed by customer deposits and bonds issued by Alpha Bank. These funds may be divided in two categories: a) Customer deposits used to cover cash needs b) Customer deposits and bonds used for investment purposes. The Bank monitors its liquidity risk on a ordinary basis by computing two liquidity Ratios: * The Liquid Asset Ratio * The Short -term Asset-Liability Mismatch Ratio The trend of these indicators in conjunction with theoretical changes in the volumes of assets and liab ilities is commonly evaluated. Each year the budget is used to specify the financing necessities of the Bank and Group so that liquidity ratios stay in the desired limits the whole year. (Alpha Bank Business Review, 2008) Millennium Bank The attitude of this Bank on Liquidity Management is to make certain that there is an adequate quantity of funds to cover the liabilities when they due, in normal and abnormal circumstances without serious effects on the profits and the reputation of the institution. The Treasury section of the Bank exchanges information with other departments in order to define the requirements and the anticipated cash flow. Liquidity indexes are subject to crisis condition simulations with a number of dissimilar scenarios. The institution estimates on a daily and quarterly basis the following ratios: * Liquid Assets Capital Ratio * Assets-Liabilities Gap Ratio The Management of the liquidity risk is approved by the Liquidity Management Committee. Conclusion The aim of this effort was to analyze the magnitude of liquidity risk and the way it is handled by the managers. The susceptibility to this is a characteristic of the modern banking sector and consequently it is compulsory to oversee it taking always into consideration the dimension of time. The bright side of the issue is that there are ways to estimate it and leave at the discretion of each bank what method to follow according to its philosophy. In the case of maladminister, the consequences can be detrimental not only for each institution but for the entire economy and this is the reason that make their protection imperative. References: * Casu, B. and Girardone, C. and Molyneux, P. (2006) Introduction to Banking, England: Prentice Hall. * Glantz, M. with contributions by Moodys and KMV and Mum, J. (c2003) Managing bank risk: an introduction to broad-base credit engineering, Amsterdam: Academic Press. * Greuning, H. and Bratanovic, S.B. (2003) Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, Washington: The World Bank * Heffernan, S. A. (1956) Modern Banking, England : Wiley. * Rose, P. S. and Hudgins, S. C. (c2008) Bank Management Financial Services, NY: Mc Graw- Hill. * Saunders, An. and Cornett, M.M. (1949) Financial institutions management: a risk management approach, NY: Mc Graw- Hill International Edition. Websites: * Alpha Bank Business Review (2008) Available: https://www. Alpha.gr/files/investorrelations/APOLOGISMOS_2008_EN.pdf * MILLENNIUM BANK S.A. , Consolidated Financial Statements based on the International Financial Reporting Standards adopted by the European Union the year ended on December 31, 2008 Available: https://www.millenniumbank.gr/NR/rdonlyres/48D2F078-BA8E-4C2E-B9A3-DDF29BDF3B65/0/Notes_Consolidated_Group2008EN.pdf * https://en.wikipedia.org/wiki/Lender_of_last_resort * https://www.investopedia.com/terms/l/lenderoflastresort.asp * https://www.yourdictionary.com/finance/lender-of-last-resort * https://www.investopedia.com/terms/t/too-big-to-fail.asp * https://en.wikipedia.org/wiki/Too_Big_to_Fail * https://en.wikipedia.org/wiki/Bank_run * https://www.econlib.org/library/Enc/BankRuns.html * https://www.businessdictionary.com/definition/maturity-matching.html * https://en.wikipedia.org/wiki/Bank_run * https://www.ecb.int/pub/pdf/scpwps/ecbwp100 8.pdf * https://www.investorwords.com/2841/liquidity_risk.html * https://en.wikipedia.org/wiki/marketliquidity * https://en.wikipedia.org/wiki/liquidityrisk * https://www.bis.org/pub/bcbs138.pdf. * https://fic.wharton .upenn.edu/fic/papers/07/po735html * https://www.federalreserve.gov/newsevents/press/bcreg/20090630a.htm * https://en.wikipedia.org/wiki/Fractional-reserve_banking