RISK MANAGEMENT - ADDITIONAL READING MATERIAL

LIQUIDITY RISK MANAGEMENT

1. Introduction:

Liquidity is a banks capacity to fund increase in assets and meet both expected
and unexpected cash and collateral obligations at reasonable cost and without
incurring unacceptable losses. Liquidity risk is the inability of a bank to meet such
obligations as they become due, without adversely affecting the banks financial
condition. Effective liquidity risk management helps ensure a banks ability to
meet its obligations as they fall due and reduces the probability of an adverse
situation developing. This assumes significance on account of the fact that
liquidity crisis, even at a single institution, can have systemic implications..

To put it in plain vanilla terms, liquidity is having enough cash to meet the current
needs and liquidity risk is the current and prospective risk to a bank's earnings
and equity arising out its inability to meet the obligations when they become due.
Thus, effective liquidity risk management is the management of liquidity by
raising sufficient funds either by increasing liabilities or by converting assets
promptly and at a reasonable cost. It has now become imperative for banks to
have an adequate liquidity risk management process commensurate with it's size,
complexity and liquidity risk profile as one size does not fit all.
Liquidity problems arise on account of the mismatches in the timing of inflows
and outflows. Per se, the liabilities being the sources of funds are inflows while
the assets being application of funds are outflows. However, in the context of
Liquidity Risk Management, we need to look at this issue from the point of
maturing liabilities and maturing assets; a maturing liability is an outflow while a
maturing asset is an inflow. The need for Liquidity Risk Management arises on
account of the mismatches in maturing assets and maturing liabilities.
Mismatching, as we all know, is an inherent feature of banking. Its said and said
very well too, that the crux of banking is managing mismatches. If banks were to
have perfectly matched portfolios they would neither make money nor need
treasury managers to run their business. Anyone can manage banks.

2. Liquidity Risk Management - Need & Importance:

A bank is said to be solvent if it's net worth is not negative. To put it differently, a
bank is solvent if the total realizable value of its assets is more than its outside
liabilities (i.e. other than it's equity/owned funds). As such, at any point in time, a
bank could be (i) both solvent and liquid or (ii) liquid but not solvent or (iii)
solvent but not liquid or (iv) neither solvent nor liquid. The need to stay both
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solvent and liquid therefore, makes effective liquidity management crucial for
increasing the profitability as also the long-term viability/solvency of a bank. This
also highlights the importance of the need of having the best Liquid Risk
Management practices in place in Banks.
We can very well imagine what could happen to a bank if a depositor wanting to
withdraw his deposit is told to do so later or the next day in view of non-
availability of cash. The consequences could be severe and may even sound the
death knell of the bank. Any bank, however, strong it may be, would not be able
to survive if all the depositors queue up demanding their money back.
A Liquidity problem in a bank could be the first symptom of financial trouble
brewing and shall need to be assessed and addressed on an enterprise-wide basis
quickly and effectively, as such problems can not only cause significant
disruptions on either side of a bank's balance sheet but can also transcend
individual banks to cause systemic disruptions. Banks play a significant role as
liquidity providers in the financial system and to play it effectively they need to
have sound liquidity risk management systems in place. With greater opening up
of the world economies and easier cross border flows of funds, the repercussions
of liquidity disturbances in one financial system could cause ripples in others. The
recent sub-prime crisis in the US and its impact on others, stands ample
testimony to this reality. Liquidity Risk Management, thus, is of critical
importance not only to bankers but to the regulators as well.
Some Key Considerations in LRM include

(i) Availability of liquid assets,

(ii) Extent of volatility of the deposits,
(iii) Degree of reliance on volatile sources of funding,
(iv) Level of diversification of funding sources,
(v) Historical trend of stability of deposits,
(vi) Quality of maturing assets,
(vii) Market reputation,
(viii) Availability of undrawn standbys,
(ix) Impact of off balance sheet exposures on the balance sheet, and
(x) Contingency plans.
Some of the issues that need to be kept in view while managing liquidity include
(i) The extent of operational liquidity, reserve liquidity and contingency
liquidity that are required
(ii) The impact of changes in the market or economic condition on the
liquidity needs
(iii) The availability, accessibility and cost of liquidity
(iv) The existence of early warning systems to facilitate prompt action prior
to surfacing of the problem and
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 (v) The efficacy of the processes in place to ensure successful execution of
the solutions in times of need.

3. Potential Liquidity Risk Drivers:

The internal and external factors in banks that may potentially lead to liquidity
risk problems in Banks are as under:
Internal Banking Factors External Banking Factors
High off-balance sheet exposures. Very sensitive financial markets
depositors.
The banks rely heavily on the short- External and internal economic shocks.
term corporate deposits.
A gap in the maturity dates of assets Low/slow economic performances.
and liabilities.
The banks rapid asset expansions Decreasing depositors trust on the
exceed the available funds on the banking sector.
liability side
Concentration of deposits in the short Non-economic factors
term Tenor
Less allocation in the liquid government Sudden and massive liquidity
instruments. withdrawals from depositors.
Fewer placements of funds in long-term Unplanned termination of government
deposits. deposits.

4. Types of Liquidity Risk:

Banks face the following types of liquidity risk:

(i) Funding Liquidity Risk the risk that a bank will not be able to meet efficiently
the expected and unexpected current and future cash flows and collateral
needs without affecting either its daily operations or its financial condition.
(ii) Market Liquidity Risk the risk that a bank cannot easily offset or eliminate a
position at the prevailing market price because of inadequate market depth or
market disruption.

5. Principles for Sound Liquidity Risk Management:

After the global financial crisis, in recognition of the need for banks to improve
their liquidity risk management, the Basel Committee on Banking Supervision
(BCBS) published Principles for Sound Liquidity Risk Management and

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Supervision in September 2008. The broad principles for sound liquidity risk
management by banks as envisaged by BCBS are as under:

Fundamental principle for the management and supervision of liquidity risk

Principle 1 A bank is responsible for the sound management of liquidity risk. A
bank should establish a robust liquidity risk management
framework that ensures it maintains sufficient liquidity, including a
cushion of unencumbered, high quality liquid assets, to withstand
a range of stress events, including those involving the loss or
impairment of both unsecured and secured funding sources.
Supervisors should assess the adequacy of both a banks liquidity
risk management framework and its liquidity position and should
take prompt action if a bank is deficient in either area in order to
protect depositors and to limit potential damage to the financial
system.
Governance of liquidity risk management
Principle 2 A bank should clearly articulate a liquidity risk tolerance that is
appropriate for its business strategy and its role in the financial
system.
Principle 3 Senior management should develop a strategy, policies and
practices to manage liquidity risk in accordance with the risk
tolerance and to ensure that the bank maintains sufficient liquidity.
Senior management should continuously review information on
the banks liquidity developments and report to the board of
directors on a regular basis. A banks board of directors should
review and approve the strategy, policies and practices related to
the management of liquidity at least annually and ensure that
senior management manages liquidity risk effectively.
Principle 4 A bank should incorporate liquidity costs, benefits and risks in the
internal pricing, performance measurement and new product
approval process for all significant business activities (both on- and
off-balance sheet), thereby aligning the risk-taking incentives of
individual business lines with the liquidity risk exposures their
activities create for the bank as a whole.
Measurement and management of liquidity risk
Principle 5 A bank should have a sound process for identifying, measuring,
monitoring and controlling liquidity risk. This process should
include a robust framework for comprehensively projecting cash
flows arising from assets, liabilities and off-balance sheet items
over an appropriate set of time horizons.
Principle 6 A bank should actively monitor and control liquidity risk exposures
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 and funding needs within and across legal entities, business lines
and currencies, taking into account legal, regulatory and
operational limitations to the transferability of liquidity.
Principle 7 A bank should establish a funding strategy that provides effective
diversification in the sources and tenor of funding. It should
maintain an ongoing presence in its chosen funding markets and
strong relationships with funds providers to promote effective
diversification of funding sources. A bank should regularly gauge its
capacity to raise funds quickly from each source. It should identify
the main factors that affect its ability to raise funds and monitor
those factors closely to ensure that estimates of fund raising
capacity remain valid.
Principle 8 A bank should actively manage its intraday liquidity positions and
risks to meet payment and settlement obligations on a timely basis
under both normal and stressed conditions and thus contribute to
the smooth functioning of payment and settlement systems.
Principle 9 A bank should actively manage its collateral positions,
differentiating between encumbered and unencumbered assets. A
bank should monitor the legal entity and physical location where
collateral is held and how it may be mobilised in a timely manner.
Principle 10 A bank should conduct stress tests on a regular basis for a variety
of short-term and protracted institution-specific and market-wide
stress scenarios (individually and in combination) to identify
sources of potential liquidity strain and to ensure that current
exposures remain in accordance with a banks established liquidity
risk tolerance. A bank should use stress test outcomes to adjust its
liquidity risk management strategies, policies, and positions and to
develop effective contingency plans.
Principle 11 A bank should have a formal contingency funding plan (CFP) that
clearly sets out the strategies for addressing liquidity shortfalls in
emergency situations. A CFP should outline policies to manage a
range of stress environments, establish clear lines of responsibility,
include clear invocation and escalation procedures and be regularly
tested and updated to ensure that it is operationally robust.
Principle 12 A bank should maintain a cushion of unencumbered, high quality
liquid assets to be held as insurance against a range of liquidity
stress scenarios, including those that involve the loss or
impairment of unsecured and typically available secured funding
sources. There should be no legal, regulatory or operational
impediment to using these assets to obtain funding.

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Public disclosure
Principle 13 A bank should publicly disclose information on a regular basis that
enables market participants to make an informed judgment about
the soundness of its liquidity risk management framework and
liquidity position.

Thus, a sound liquidity risk management system would envisage that:

i) A bank should establish a robust liquidity risk management framework.
ii) The Board of Directors (BoD) of a bank should be responsible for sound
management of liquidity risk and should clearly articulate a liquidity risk tolerance
appropriate for its business strategy and its role in the financial system.
iii) The BoD should develop strategy, policies and practices to manage liquidity
risk in accordance with the risk tolerance and ensure that the bank maintains
sufficient liquidity. The BoD should review the strategy, policies and practices at
least annually.
iv) Top management/ALCO should continuously review information on banks
liquidity developments and report to the BoD on a regular basis.
v) A bank should have a sound process for identifying, measuring, monitoring and
controlling liquidity risk, including a robust framework for comprehensively
projecting cash flows arising from assets, liabilities and off-balance sheet items
over an appropriate time horizon.
vi) A banks liquidity management process should be sufficient to meet its funding
needs and cover both expected and unexpected deviations from normal
operations.
vii) A bank should incorporate liquidity costs, benefits and risks in internal pricing,
performance measurement and new product approval process for all significant
business activities.
viii) A bank should actively monitor and manage liquidity risk exposure and
funding needs within and across legal entities, business lines and currencies,
taking into account legal, regulatory and operational limitations to transferability
of liquidity.
ix) A bank should establish a funding strategy that provides effective
diversification in the source and tenor of funding, and maintain ongoing presence
in its chosen funding markets and counterparties, and address inhibiting factors
in this regard.
x) Senior management should ensure that market access is being actively
managed, monitored, and tested by the appropriate staff.
xi) A bank should identify alternate sources of funding that strengthen its capacity
to withstand a variety of severe bank specific and market-wide liquidity shocks.
xii) A bank should actively manage its intra-day liquidity positions and risks.
xiii) A bank should actively manage its collateral positions.
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xiv) A bank should conduct stress tests on a regular basis for short-term and
protracted institution-specific and market-wide stress scenarios and use stress
test outcomes to adjust its liquidity risk management strategies, policies and
position and develop effective contingency plans.
xv) Senior management of banks should monitor for potential liquidity stress
events by using early warning indicators and event triggers. Early warning signals
may include, but are not limited to, negative publicity concerning an asset class
owned by the bank, increased potential for deterioration in the banks financial
condition, widening debt or credit default swap spreads, and increased concerns
over the funding of off- balance sheet items.
xvi) To mitigate the potential for reputation contagion, a bank should have a
system of effective communication with counterparties, credit rating agencies,
and other stakeholders when liquidity problems arise.
xvii) A bank should have a formal contingency funding plan (CFP) that clearly sets
out the strategies for addressing liquidity shortfalls in emergency situations. A
CFP should delineate policies to manage a range of stress environments, establish
clear lines of responsibility, and articulate clear implementation and escalation
procedures.
xviii) A bank should maintain a cushion of unencumbered, high quality liquid
assets to be held as insurance against a range of liquidity stress scenarios.
xix) A bank should publicly disclose its liquidity information on a regular basis that
enables market participants to make an informed judgment about the soundness
of its liquidity risk management framework and liquidity position.

6. Governance of Liquidity Risk Management:

The Reserve Bank had issued guidelines on Asset Liability Management (ALM)
system, covering inter alia liquidity risk management system, in February 1999
and October 2007. Successful implementation of any risk management process
has to emanate from the top management in the bank with the demonstration of
its strong commitment to integrate basic operations and strategic decision
making with risk management. Ideally, the organisational set up for liquidity risk
management should be as under:
A. The Board of Directors (BoD):
The BoD should have the overall responsibility for management of liquidity risk.
The Board should decide the strategy, policies and procedures of the bank to
manage liquidity risk in accordance with the liquidity risk tolerance/limits as
detailed in paragraph 14. The risk tolerance should be clearly understood at all
levels of management. The Board should also ensure that it understands the
nature of the liquidity risk of the bank including liquidity risk profile of all
branches, subsidiaries and associates (both domestic and overseas), periodically
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reviews information necessary to maintain this understanding, establishes
executive-level lines of authority and responsibility for managing the banks
liquidity risk, enforces managements duties to identify, measure, monitor, and
manage liquidity risk and formulates/reviews the contingent funding plan.
B. The Risk Management Committee:
The Risk Management Committee, which reports to the Board, consisting of Chief
Executive Officer (CEO)/Chairman and Managing Director (CMD) and heads of
credit, market and operational risk management committee should be
responsible for evaluating the overall risks faced by the bank including liquidity
risk. The potential interaction of liquidity risk with other risks should also be
included in the risks addressed by the risk management committee.
C. The Asset-Liability Management Committee (ALCO):
The Asset-Liability Management Committee (ALCO) consisting of the banks top
management should be responsible for ensuring adherence to the risk
tolerance/limits set by the Board as well as implementing the liquidity risk
management strategy of the bank in line with banks decided risk management
objectives and risk tolerance.
D. The Asset Liability Management (ALM) Support Group:
The ALM Support Group consisting of operating staff should be responsible for
analysing, monitoring and reporting the liquidity risk profile to the ALCO. The
group should also prepare forecasts (simulations) showing the effect of various
possible changes in market conditions on the banks liquidity position and
recommend action needed to be taken to maintain the liquidity position/adhere
to banks internal limits.

7. Liquidity Risk Management Policy, Strategies and Practices:

The first step towards liquidity management is to put in place an effective

liquidity risk management policy, which inter alia, should spell out the liquidity
risk tolerance, funding strategies, prudential limits, system for measuring,
assessing and reporting / reviewing liquidity, framework for stress testing,
liquidity planning under alternative scenarios/formal contingent funding plan,
nature and frequency of management reporting, periodical review of
assumptions used in liquidity projection, etc. The policy should also address
liquidity separately for individual currencies, legal entities like subsidiaries, joint
ventures and associates, and business lines, when appropriate and material, and
should place limits on transfer of liquidity keeping in view the regulatory, legal
and operational constraints.

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The BoD or its delegated committee of board members should oversee the
establishment and approval of policies, strategies and procedures to manage
liquidity risk, and review them at least annually.

7.1 Liquidity Risk Tolerance:

Banks should have an explicit liquidity risk tolerance set by the Board of
Directors. The risk tolerance should define the level of liquidity risk that the bank
is willing to assume, and should reflect the banks financial condition and funding
capacity. The tolerance should ensure that the bank manages its liquidity in
normal times in such a way that it is able to withstand a prolonged period of,
both institution specific and market wide stress events. The risk tolerance
articulation by a bank should be explicit, comprehensive and appropriate as per
its complexity, business mix, liquidity risk profile and systemic significance. They
may also be subject to sensitivity analysis. The risk tolerance could be specified by
way of fixing the tolerance levels for various maturities under flow approach
depending upon the banks liquidity risk profile as also for various ratios under
stock approach. Risk tolerance may also be expressed in terms of minimum
survival horizons (without Central Bank or Government intervention) under a
range of severe but plausible stress scenarios, chosen to reflect the particular
vulnerabilities of the bank. The key assumptions may be subject to a periodic
review by the Board.

7.2 Strategy for Managing Liquidity Risk:

The strategy for managing liquidity risk should be appropriate for the nature,
scale and complexity of a banks activities. In formulating the strategy,
banks/banking groups should take into consideration its legal structures, key
business lines, the breadth and diversity of markets, products, jurisdictions in
which they operate and home and host country regulatory requirements, etc.
Strategies should identify primary sources of funding for meeting daily operating
cash outflows, as well as expected and unexpected cash flow fluctuations.

8. Management of Liquidity Risk:

A bank should have a sound process for identifying, measuring, monitoring and
mitigating liquidity risk as enumerated below:

8.1 Identification:

A bank should define and identify the liquidity risk to which it is exposed for each
major on and off-balance sheet position, including the effect of embedded

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options and other contingent exposures that may affect the banks sources and
uses of funds and for all currencies in which a bank is active.

8.2 Measurement of Liquidity Risk:

There are two simple ways of measuring liquidity; one is the stock approach and
the other, flow approach. The stock approach is the first step in evaluating
liquidity. Under this method, certain ratios, like liquid assets to short term total
liabilities, purchased funds to total assets, core deposits to total assets, loan to
deposit ratio, etc. are calculated and compared to the benchmarks that a bank
has set for itself. While the stock approach helps up in looking at liquidity from
one angle, it does not reveal the intrinsic liquidity profile of a bank.
The flow approach, on the other hand, forecasts liquidity at different points of
time. It looks at the liquidity requirements of today, tomorrow, the day
thereafter, in the next seven to 14 days and so on. The maturity ladder, thus,
constructed helps in tracking the cash flow mismatches over a series of specified
time periods. The liquidity controls, apart from being fixed maturity-bucket wise,
should also encompass maximum cumulative mismatches across the various time
bands.
9. Ratios in respect of Liquidity Risk Management:

Certain critical ratios in respect of liquidity risk management and their

significance for banks are given below. Banks may monitor these ratios by putting
in place an internally defined limit approved by the Board for these ratios. The
industry averages for these ratios are given for information of banks. They may fix
their own limits, based on their liquidity risk management capabilities, experience
and profile. The stock ratios are meant for monitoring the liquidity risk at the solo
bank level. Banks may also apply these ratios for monitoring liquidity risk in major
currencies, viz. US Dollar, Pound Sterling, Euro and Japanese Yen at the solo bank
level.

Sl. Ratio Significance Industry

No. Average
(in %)
1. (Volatile liabilities Measures the extent to which volatile 40
Temporary Assets) money supports banks basic earning
/(Earning Assets assets. Since the numerator represents
Temporary Assets) short-term, interest sensitive funds, a high
and positive number implies some risk of
illiquidity.
2. Core deposits/Total Measures the extent to which assets are 50
Assets funded through stable deposit base.

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3. (Loans + mandatory Loans including mandatory cash reserves 80
SLR + mandatory CRR and statutory liquidity investments are
+ Fixed Assets)/Total least liquid and hence a high ratio signifies
Assets the degree of illiquidity embedded in the
balance sheet.
4. (Loans + mandatory Measure the extent to which illiquid assets 150
SLR + mandatory CRR are financed out of core deposits.
+ Fixed Assets) / Core
Deposits
5. Temporary Measures the extent of available liquid 40
Assets/Total Assets assets. A higher ratio could impinge on the
asset utilisation of banking system in
terms of opportunity cost of holding
liquidity.
6. Temporary Assets/ Measures the cover of liquid investments 60
Volatile Liabilities relative to volatile liabilities. A ratio of less
than 1 indicates the possibility of a
liquidity problem.
7. Volatile Measures the extent to which volatile 60
Liabilities/Total Assets liabilities fund the balance sheet.
Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year). Letters
of credit full outstanding. Component-wise CCF of other contingent credit and
commitments. Swap funds (buy/ sell) up to one year. Current deposits (CA) and
Savings deposits (SA) i.e. (CASA) deposits reported by the banks as payable within
one year (as reported in structural liquidity statement) are included under volatile
liabilities. Borrowings include from RBI, call, other institutions and refinance.
Temporary assets =Cash + Excess CRR balances with RBI + Balances with banks +
Bills purchased/discounted up to 1 year + Investments up to one year + Swap
funds (sell/ buy) up to one year.
Earning Assets = Total assets (Fixed assets + Balances in current accounts with
other banks + Other assets excluding leasing + Intangible assets)

Core deposits = All deposits (including CASA) above 1 year (as reported in
structural liquidity statement)+ net worth

The above stock ratios are only illustrative and banks could also use other
measures / ratios. For example to identify unstable liabilities and liquid asset
coverage ratios banks may include ratios of wholesale funding to total liabilities,
potentially volatile retail (e.g. high cost or out of market) deposits to total
deposits, and other liability dependency measures, such as short term borrowings
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10.Stress Testing:

Stress testing should form an integral part of the overall governance and liquidity
risk management culture in banks. A bank should conduct stress tests on a
regular basis for a variety of short term and protracted bank specific and market
wide stress scenarios (individually and in combination). In designing liquidity
stress scenarios, the nature of the banks business, activities and vulnerabilities
should be taken into consideration so that the scenarios incorporate the major
funding and market liquidity risks to which the bank is exposed. These include
risks associated with its business activities, products (including complex financial
instruments and off-balance sheet items) and funding sources. The defined
scenarios should allow the bank to evaluate the potential adverse impact these
factors can have on its liquidity position. While historical events may serve as a
guide, a banks judgment also plays an important role in the design of stress tests.

Stress tests outcomes should be used to identify and quantify sources of

potential liquidity strain and to analyse possible impacts on the banks cash flows,
liquidity position, profitability and solvency. The results of stress tests should be
discussed thoroughly by ALCO. Remedial or mitigating actions should be
identified and taken to limit the banks exposures, to build up a liquidity cushion
and to adjust the liquidity profile to fit the risk tolerance. The results should also
play a key role in shaping the banks contingent funding planning and in
determining the strategy and tactics to deal with events of liquidity stress.

The stress test results and the action taken should be documented by banks and
made available to the Reserve Bank / Inspecting Officers as and when required. If
the stress test results indicate any vulnerability, these should be reported to the
Board and a plan of action charted out immediately. The Department of Banking
Supervision, Central Office, Reserve Bank of India should also be kept informed
immediately in such cases.

11.Contingency Funding Plan:

A bank should formulate a contingency funding plan (CFP) for responding to

severe disruptions which might affect the banks ability to fund some or all of its
activities in a timely manner and at a reasonable cost. CFPs should prepare the
bank to manage a range of scenarios of severe liquidity stress that include both
bank specific and market-wide stress and should be commensurate with a banks
complexity, risk profile, scope of operations. Contingency plans should contain
details of available / potential contingency funding sources and the amount /
estimated amount which can be drawn from these sources, clear escalation /
prioritisation procedures detailing when and how each of the actions can and
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should be activated and the lead time needed to tap additional funds from each of
the contingency sources.

Contingency plans must be tested regularly to ensure their effectiveness and

operational feasibility and should be reviewed by the Board at least on an annual
basis.

12.Overseas Operations of the Indian Banks Branches and Subsidiaries and

Branches of Foreign banks in India:

A banks liquidity policy and procedures should also provide detailed procedures
and guidelines for their overseas branches/subsidiaries to manage their
operational liquidity on an ongoing basis. Similarly, foreign banks operating in
India should also be self reliant with respect to liquidity maintenance and
management.

13.BROAD NORMS IN RESPECT OF LIQUIDITY MANAGEMENT:

Some of the broad norms in respect of liquidity management are as follows:

i. Banks should not normally assume voluntary risk exposures extending

beyond a period of ten years.
ii. Banks should endeavour to broaden their base of long- term resources and
funding capabilities consistent with their long term assets and
commitments.
iii. The limits on maturity mismatches shall be established within the following
tolerance levels: (a) long term resources should not fall below 70% of long
term assets; and (b) long and medium term resources together should not
fall below 80% of the long and medium term assets. These controls should
be undertaken currency-wise, and in respect of all such currencies which
individually constitute 10% or more of a banks consolidated overseas
balance sheet. Netting of inter-currency positions and maturity gaps is not
allowed. For the purpose of these limits, short term, medium term and long
term are defined as under:

Short-term: those maturing within 6 months

Medium- those maturing in 6 months and longer but
term: within 3 years
Long-term: those maturing in 3 years and longer

1. The monitoring system should be centralised in the International Division

(ID) of the bank for controlling the mismatch in asset-liability structure of
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 the overseas sector on a consolidated basis, currency-wise. The ID of each
bank may review the structural maturity mismatch position at quarterly
intervals and submit the review/s to the top management of the bank.

14.Liquidity Across Currencies

Banks should have a measurement, monitoring and control system for liquidity
positions in the major currencies in which they are active. For assessing the
liquidity mismatch in foreign currencies, as far as domestic operations are
concerned, banks are required to prepare Maturity and Position (MAP)
statements according to the extant instructions. A bank should also undertake
separate analysis of its strategy for each major currency individually by taking into
account the outcome of stress testing.

15.Management Information System (MIS)

A bank should have a reliable MIS designed to provide timely and forward-looking
information on the liquidity position of the bank and the Group to the Board and
ALCO, both under normal and stress situations. The MIS should cover liquidity
positions in all currencies in which the bank conducts its business both on a
subsidiary / branch basis (in all countries in which the bank is active) and on an
aggregate group basis. It should capture all sources of liquidity risk, including
contingent risks and those arising from new activities, and have the ability to
furnish more granular and time sensitive information during stress events.

Liquidity risk reports should provide sufficient detail to enable management to

assess the sensitivity of the bank to changes in market conditions, its own
financial performance, and other important risk factors. It may include cash flow
projections, cash flow gaps, asset and funding concentrations, critical
assumptions used in cash flow projections, funding availability, compliance to
various regulatory and internal limits on liquidity risk management, results of
stress tests, key early warning or risk indicators, status of contingent funding
sources, or collateral usage, etc.

16.Reporting to the Reserve Bank of India

Banks are required to submit the liquidity return, as per the prescribed format to
the Chief General Manager-in-Charge, Department of Banking Supervision,
Reserve Bank of India, Central Office, World Trade Centre, Mumbai.

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17.Internal Controls

A bank should have appropriate internal controls, systems and procedures to

ensure adherence to liquidity risk management policies and procedure as also
adequacy of liquidity risk management functioning.

Management should ensure that an independent party regularly reviews and

evaluates the various components of the banks liquidity risk management
process. These reviews should assess the extent to which the banks liquidity risk
management complies with the regulatory/supervisory instructions as well as its
own policy. The independent review process should report key issues requiring
immediate attention, including instances of non compliance to various
guidance/limits for prompt corrective action consistent with the Board approved
policy.

Basel III Framework on Liquidity Standards Liquidity Coverage Ratio (LCR),

Liquidity Risk Monitoring Tools and LCR Disclosure Standards

Liquidity Coverage Ratio

1. Introduction:
With the objective of promoting a more resilient banking sector, the Basel III
International framework for liquidity risk measurement, standards and
monitoring was issued in December 2010. The Basel Committee prescribed two
minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding
Ratio (NSFR) for funding liquidity to achieve two separate but complementary
objectives.
While the LCR promotes short-term resilience of banks to potential liquidity
disruptions by ensuring that they have sufficient high quality liquid assets (HQLAs)
to survive an acute stress scenario lasting for 30 days, the NSFR promotes
resilience over longer-term time horizons by requiring banks to fund their
activities with more stable sources of funding on an ongoing basis. In addition, a
set of five monitoring tools to be used for monitoring the liquidity risk exposures
of banks was also prescribed in the said document.
2. Objective:
The LCR standard aims to ensure that a bank maintains an adequate level of
unencumbered HQLAs that can be converted into cash to meet its liquidity needs
for a 30 calendar day time horizon under a significantly severe liquidity stress
scenario specified by supervisors. At a minimum, the stock of liquid assets should
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enable the bank to survive until day 30 of the stress scenario, by which time it is
assumed that appropriate corrective actions can be taken.
3. Scope:
To start with, the LCR and monitoring tools would be applicable for Indian banks
at whole bank level only i.e. on a stand-alone basis including overseas operations
through branches. However, banks should endeavour to move over to meeting
the standard at consolidated level also. For foreign banks operating as branches
in India, the framework would be applicable on stand- alone basis (i.e. for Indian
operations only).

4. Definition of LCR:
Stock of high quality liquid assets (HQLAs) 100%
Total net cash outflows over the next 30 calendar days

The LCR requirement is binding on banks from January 1, 2015. However, to

provide a transition time for banks, Reserve Bank of India has permitted a gradual
increase in the ratio starting with a minimum 60% for the calendar year 2015 as
per the time-line given below:

January 1 January 1 January 1 January 1 January 1

2015 2016 2017 2018 2019
Minimum 60% 70% 80% 90% 100%
LCR
Banks should, however, strive to achieve a higher ratio than the minimum
prescribed above as an effort towards better liquidity risk management.

With effect from January 1, 2019, i.e. after the phase-in arrangements are
complete, the LCR should be minimum 100% (i.e. the stock of HQLA should at
least equal total net cash outflows) on an ongoing basis because the stock of
unencumbered HQLA is intended to serve as a defence against the potential
onset of liquidity stress. During a period of financial stress, however, banks may
use their stock of HQLA, and thereby falling below 100%. Banks shall be required
to immediately report to RBI (Department of Banking Operations and
Development as also Department of Banking Supervision) such use of stock of
HQLA along with reasons for such usage and corrective steps initiated to rectify
the situation.

The stress scenario specified by the BCBS entails a combined idiosyncratic and
market-wide shock that would result in:
a) the run-off of a proportion of retail deposits;
b) a partial loss of unsecured wholesale funding capacity;
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c) a partial loss of secured, short-term financing with certain collateral and
counterparties;
d) additional contractual outflows that would arise from a downgrade in the
banks public credit rating by up to three notches, including collateral posting
requirements;
e) increases in market volatilities that impact the quality of collateral or potential
future exposure of derivative positions and thus require larger collateral haircuts
or additional collateral, or lead to other liquidity needs;
f) unscheduled draws on committed but unused credit and liquidity facilities that
the bank has provided to its clients; and
g) the potential need for the bank to buy back debt or honour non-contractual
obligations in the interest of mitigating reputational risk.
5 High Quality Liquid Assets:
5.1 Liquid assets comprise of high quality assets that can be readily sold or used
as collateral to obtain funds in a range of stress scenarios. They should be
unencumbered i.e. without legal, regulatory or operational impediments. Assets
are considered to be high quality liquid assets, if they can be easily and
immediately converted into cash at little or no loss of value. The liquidity of an
asset depends on the underlying stress scenario, the volume to be monetized and
the timeframe considered. Nevertheless, there are certain assets that are more
likely to generate funds without incurring large discounts due to fire-sales even in
times of stress.
5.2 While the fundamental characteristics of these assets include low credit and
market risk; ease and certainty of valuation; low correlation with risky assets and
listing on a developed and recognized exchange market, the market related
characteristics include active and sizeable market; presence of committed market
makers; low market concentration and flight to quality (tendencies to move into
these types of assets in a systemic crisis).
5.3 There are two categories of assets which can be included in the stock of
HQLAs, viz. Level 1 and Level 2 assets. Level 2 assets are sub-divided into Level 2A
and Level 2B assets on the basis of their price-volatility. Assets to be included in
each category are those that the bank is holding on the first day of the stress
period.

6. Calculation of LCR:
As stated in the definition of LCR, it is a ratio of two factors, viz, the Stock of HQLA
and the Net Cash Outflows over the next 30 calendar days. Therefore,
computation of LCR of a bank will require calculations of the numerator and
denominator of the ratio, as detailed in the RBI Circular.

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7. Liquidity Risk Monitoring Tools:
7.1 In addition to the two liquidity standards, the Basel III framework also
prescribes five monitoring tools / metrics for better monitoring a bank's liquidity
position. These metrics along with their objective and the prescribed returns are
as under:
(a) Contractual Maturity Mismatch
The contractual maturity mismatch profile identifies the gaps between the
contractual inflows and outflows of liquidity for defined time bands. These
maturity gaps indicate how much liquidity a bank would potentially need to raise
in each of these time bands if all outflows occurred at the earliest possible date.
This metric provides insight into the extent to which the bank relies on maturity
transformation under its current contracts.
(b) Concentration of Funding
This metric is meant to identify those sources of funding that are of such
significance, the withdrawal of which could trigger liquidity problems. The metric
thus encourages the diversification of funding sources recommended in the Basel
Committee's Sound Principles. This metrics aims to address the funding
concentration of banks by monitoring their funding from each significant
counterparty, each significant product / instrument and each significant currency.
(c) Available Unencumbered Assets
This metric provides supervisors with data on the quantity and key characteristics
of banks' available unencumbered assets. These assets have the potential to be
used as collateral to raise additional secured funding in secondary markets and /
or are eligible at central banks.
(d) LCR by Significant Currency
While the LCR standard is required to be met in one single currency, in order to
better capture potential currency mismatches, the LCR in each significant
currency needs to be monitored.
(e) Market-related Monitoring Tools
This includes high frequency market data that can serve as early warning
indicators in monitoring potential liquidity difficulties at banks.
8. Basel III Liquidity Returns:
S. No. Name of the Basel III Frequency of Time period by which
Liquidity Return (BLR) submission required to be
reported
1. Statement on Liquidity Monthly within 15 days
Coverage Ratio (LCR)-BLR-1
2. Statement of Funding Monthly within 15 days

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 Concentration - BLR-
3. Statement of Available Quarterly within a month
Unencumbered Assets - BLR-
3
4. LCR by Significant Currency - Monthly within a month
BLR-4
5. Statement on Other Monthly within 15 days
Information on Liquidity -
BLR-5
9. LCR Disclosure Standards:
9.1 Banks are required to disclose information on their LCR in their annual
financial statements under Notes to Accounts, starting with the financial year
ending March 31, 2015, for which the LCR related information needs to be
furnished only for the quarter ending March 31, 2015. However, in subsequent
annual financial statements, the disclosure should cover all the four quarters of
the relevant financial year.

10. Net Stable Funding Ratio (NSFR):

10.1 This ratio aims at promoting medium to long term structure funding of
assets and activities of the Banks. BCBS aims to trial this ratio from 2012 and
makes it mandatory in January 2018.
RBI released its Draft guidelines on NSFR on May 28, 2015. The objective of NSFR
is to ensure that banks maintain a stable funding profile in relation to the
composition of their assets and off-balance sheet activities. A sustainable funding
structure is intended to reduce the probability of erosion of a banks liquidity
position due to disruptions in its regular sources of funding that would increase
the risk of its failure and potentially lead to broader systemic stress. The NFSR
limits overreliance on short-term wholesale funding, encourages better
assessment of funding risk across all on- and off-balance sheet items, and
promotes funding stability. The Reserve Bank proposes to make NFSR applicable
to banks in India from January 1, 2018. (Source RBI).

10.2 Definition of the Standard Net Stable Funding Ratio:

(Available Stable Funding (ASF))/Required Stable Funding (RSF)) x 100 = Should be

100% or above.

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