What is liquidity/risk

• Liquidity is the state of having assets that can be easily changed into
cash.
• Liquidity risk arises, when there is a mismatch in the maturity pattern
of assets and liabilities.
• Liquidity risk arises because banks accept deposits and lend funds on
different terms.
• Liquidity risk arises because the bank’s loan products have an
embedded option
What is liquidity/risk
• Further, banks take upon themselves the risk of default by the
borrowers.
• They also offer lines of credit (It is an arrangement by means of which
a bank promises to make available a specified amount of credit to a
borrower as and when he wants it) for which the withdrawal schedule
is not known.
• Banks offer unrestrained liquidity to the depositors in the process
promising more liquidity than what their balance sheets provide.
Categories

Liquidity risk is broadly made up of three sub risks.

Funding risk -the need to replace net outflows of funds

Time risk - the need to compensate for non receipt of expected inflow
of funds
Call risk- the need to find new funds when contingent liabilities fall
due.
What is liquidity risk management
• It is the continuous process of raising new funds in case of a deficit
(shortfall) and investing of surplus funds when there are excesses.
• It is a defense mechanism, which protects capital from losses arising
on account of unscheduled asset sales / distress sales
Aspects of liquidity management

• Ensuring sufficient liquidity to meet all financial commitments –

mostly taken care by the preempted funds
• Maintaining profits: Liquidity is synonymous with reduced profits.
Liquid assets earn much less than the less liquid ones.
Transition to the present
Asset liability management approach
• It incorporates the features of other approaches, mainly the pools of
fund approach and the liability management approach. On account of
liberalisation, banks today operate in an environment where several
financial instruments are available to them, both as assets and liabilities.
In addition, off balance sheet business has also grown significantly. This
has brought forth many risks.
• So now banks have to adapt a structured approach of managing their
balance sheet.
• This approach of managing risks and thereby maximising returns has
become known as asset liability management.
Some of the ratios
Static approach :
• Ratio of growth in core deposits (CASA) to growth in working funds
• Volatile Liabilities Dependency Ratio
• Ratio of temporary investments to total working funds
• Ratio of Volatile liability to total working funds

Dynamic approach:
• Working funds
• Cash flow
Dynamic Approach

Maturity time bucket Assets (A) Liabilities (L) Gap (A-L)

1 day -14 days A1 L1 G1

15 days -28 days A2 L2 G2

29 days to 3 months A3 L3 G3

Over 3 months to 6 A4 L4 G4
months
Over 6 months to 12 A5 L5 G5
months
Over 1 year but less A6 L6 G6
than 3 years
Over 3 years to 5 A7 L7 G7
years
Over 5 years A8 L8 G8
• Banks face only three asset/ liability situations.
• A bank whose short duration (short term and medium term) liabilities
fund long duration (long term) assets is a short funded bank. (L1+ L2 is
greater than A1 + A2 ).
• A bank whose long duration (long term) liabilities fund short duration
(short term and medium term) assets is a long funded bank. (L3 is
greater than A3 and L1+ L2 is less than A1 + A2 ).
• A bank where the duration of the assets is similar to the duration of
liabilities is an equal funded bank.
Maturity Assets (A) Liabilities (L) Weights (W) Weighted Weighted
time buckets assets (WA) Liabilities
(WL)
1 day -14 days A1 L1 1 A1 * 1 L1 * 1

15 days -28 A2 L2 2 A2 * 2 L2 * 2
days
29 days to 3 A3 L3 3 A3 * 3 L3 * 3
months
Over 3 months A4 L4 4 A4 * 4 L4 * 4
to 6 months
Over 6 months A5 L5 5 A5 * 5 L5 * 5
to 12 months
Over 1 year A6 L6 6 A6 * 6 L6 * 6
but less than 3
years
Over 3 years A7 L7 7 A7 * 7 L7 * 7
to 5 years
Over 5 years A8 L8 8 A8 * 8 L8 * 8

Total TWA TWL

Funding index
TWA= total weighted assets
TWL= total weighted liabilities.
Index is = TWL / TWA.
An index of 0.50 implies that weighted assets are twice weighted
liabilities.
Since the weights are in the increasing order for increasing time
buckets, an index of 0.5 translates into a liquidity profile involving
funding of substantial long-term assets by short-term liabilities.
weights Liability Assets Weighted liabilities Weighted assets

1 200 60 200 60

2 50 50 100 100

3 60 200 180 600

310 310 480 760

TWL/TWA = 480/760 = 0.63 indicating that short term liabilities are funding long term assets
weights Liability Assets Weighted liabilities Weighted assets

1 60 200 60 200

2 50 50 100 100

3 200 60 600 180

310 310 760 480

TWL/TWA = 760/480 = 1.58 indicating that long term liabilities are funding short term assets
Liquidity Index
• An asset of Rs. 100 face value fetches the face value on the maturity
date. But if the same asset needs to be liquidated say 2 months
before maturity date to take care of liquidity issues at say Rs. 92 per
100 of face value there is a loss in the value the liquidity index is .92=
(0.92/1.00) and the potential loss index is 0.08
• A real estate loan of Rs. 100 is expected to fetch Rs. 90 on due date, is
liquidated at Rs. 86 today. The liquidity index is 0.86/0.90 = 0.95. If
the same loan fetches 65 today the liquidity index is 0.65/0.90 = 0.72.
The index decreases on account of larger discount in the fire sale
price.
Leverage Ratio
Leverage Ratio
Tier I +Tier II capital >9%
Capital Adequacy Ratio
Risk weighted assets

CETI >5.5%
CETI ratio
Risk weighted assets

CETI + additional capital >7%

CETI + additional capital
Risk weighted assets

Tier I ( net of deductions) > 3%

Leverage Ratio
Total Exposure
• Basel III required banks to include off-balance sheet exposures, such
as commitments to provide loans to third parties, standby letters of
credit (SLOC), acceptances, and trade letters of credit.
• The higher the Tier 1 leverage ratio is, the higher the likelihood is of
the bank withstanding negative shocks to its balance sheet.
• This is complementary to debt equity ratio
Calculation of LCR

It is a ratio of 2 factors , stock of High Quality Liquid Assets ( as numerator)and the net
cash outflows over the next 30 calendar days under stress scenarios ( as the
denominator)
High Quality Liquid Assets
Stock of HQLA = Level 1 + Level 2
Level 1 = cash + Central Bank Reserves+ Sovereign debt (investment in GOI)
Level 2 assets are government backed securities, corporate bonds and blue chip equities .
Level 2 = Level 2A + Level 2B subject to an overall cap of 40% of the total liquid assets.
Haircut of 15% for level 2A and 50% for level 2B on each of the assets.
Additionally, Level 2B assets cannot exceed 15% of the total HQLA
Cash Flows

• Net cash outflows are { max (Cash Inflow –Cash outflow), 25% of cash
outflow}
• Run off factors are applied to the liabilities to arrive at the outflows
(expected to be run off or drawn ). All liabilities falling due within 30 days
+ liabilities which have the early withdrawal option + unscheduled draw
down of committed lines are considered subject to a run off factor
• The LCR is required to be calculated assuming some stressed scenarios
( like for example 50% of retail loan will default or a run off of deposits
etc.)
• Initially Banks had to reach 100 percent LCR by Jan 2019.
• Revision in deadlines post pandemic
From date of circular (April 2020 to September 30, 2020 - 80 per cent
Oct 1, 2020 to March 31, 2021 - 90 per cent
April 1, 2021 onwards - 100 per cent
Net stable funding ratio

NSFR = Available Stable Funding (ASF)

Required Stable Funding
NSFR should be always greater than 1 over 1 year horizon

When we say available on the liability side we mean how stable they are
(will not be withdrawn) and when we say required how illiquid they are and
therefore require funding. Eg : capital is 100% stable. They are expected to
remain even under stress ( with 0% run off factor)