4.

1 Liquidity Risk Management

Liquidity Risk:
Liquidity is the ability of an institution to transform its assets into cash or
cash equivalent in a timely manner at a reasonable price to meet its
commitments as they fall due.
Liquidity risk is the probability of loss to an FI arising from a situation where‐
 there will not be enough cash and/or cash equivalents to meet the needs
of depositors and borrowers;
 sale of illiquid assets will yield less than their fair value; or
 illiquid assets cannot be sold at the desired time due to lack of buyers.
.
 Classification of Liquidity risk
 Liquidity risk can be classified into four categories:
a. Term liquidity risk (due to mismatch of maturities);
b. Withdrawal/call risk (mass disinvestment before maturity);
c. Structural liquidity risk (when the necessary funding transactions
cannot be carried out or carried out at less favorable terms); and
d. Market liquidity risk.
 4.2 Liquidity Risk Indicators
FIs can have prior signal regarding liquidity risk from some potential
internal indicators. Effective exercise and monitoring of such indicators by
management/Asset Liability Management Committee (ALCO) can
minimize liquidity risk. Examples of such internal indicators are:
a. A negative trend or significantly increased risk in any area or
product line;
b. Concentrations in either assets or liabilities;
c. Deterioration in quality of credit portfolio;
d. A decline in earnings performance or projections;
e. Rapid asset growth funded by volatile large deposit;
f. Deteriorating third party evaluation (negative rating) about the FI
and negative publicity; and
g. Unwarranted competitive pricing that potentially stresses the FIs.
 4.3 Managing Liquidity Risk
Liquidity risk management involves not only analyzing FIs' on and off‐
balance sheet positions to forecast future cash flows but also how the
funding requirement would be met. The later involves identifying the
funding market in which an FI has access, understanding the nature of
those markets, evaluating FIs current and future use of the market and
monitoring signs of confidence erosion.
FI's liquidity risk management procedures should be comprehensive and
holistic. At the minimum, they should cover formulation of overall
liquidity strategy, risk identification, measurement, and monitoring and
control process.
 4.3.1 Liquidity Risk Management Framework
An important aspect of an effective liquidity risk management system is
assessing future funding needs. By ensuring an effective liquidity risk
management system an FI can reduce the probability of an adverse
situation. Effective liquidity risk management requires both a top‐down
and a bottom‐up approach. Strategy, principles and objectives are set at
board and management levels but the data necessary to feed the risk
dashboard and analytics has to be obtained from funding desk. In
particular, intra‐day liquidity management is an integral part of an
improved liquidity risk management.
Ideally, the regular measurement reports that an FI generates will enable it
to capture significant information and monitor liquidity more rigorously.
Among all the measurement reports, liquidity gap analysis is a key tool for
assessing an FI's cash inflows against its outflows to identify the potential
for any net shortfalls going forward.
While calculating expected cash inflows and outflows, FIs must also
estimate future liquidity needs and prospective investment decisions both
in the short and long time periods. Asset Liquidity Management (ALM)
and ALCO desk must play a big role in this regard.
 4.3.2 Board Oversight
The prerequisites of an effective liquidity risk management include an
informed board, capable management staffs having relevant expertise and
efficient systems and procedures. The board should approve the strategy
and significant policies related to the management of liquidity. Generally,
the responsibilities of the board include:
a. providing guidance on the level of tolerance for liquidity risk;
b. establishing an appropriate structure for the management of liquidity
risk and identifying lines of authority and responsibility for managing
liquidity risk exposure;
c. continuously monitoring the FI’s performance and overall liquidity
risk profile through reviewing various reports;
d. ensuring that senior management takes necessary steps to identify,
measure, monitor and control liquidity risk; and
e. reviewing adequacy of the contingency plans of the institutions.
 4.3.3 Senior Management Oversight
Senior management is responsible for the implementation of sound policies and
procedures keeping in view the strategic direction and risk appetite specified by
the board. To effectively oversee the daily and long‐term management of liquidity
risk, senior management should at least:
a. develop and implement procedures and practices that translate the Board's
goals, objectives, and risk tolerances into operating standards that are well
understood by FI personnel and consistent with the institution's intent and
strategies;
b. adhere to the lines of authority and responsibility that the Board has established
for managing liquidity risk;
c. oversee the implementation and maintenance of management information and
other systems that identify, measure, monitor, and control the institution's
liquidity risk; and
d. establish effective internal controls over the liquidity risk management process
and ensure that the same is communicated to all staffs
4.4 Strategy for Managing Liquidity Risk
The liquidity risk strategy defined by Board should enunciate specific policies on
particular aspects of liquidity risk management, such as:
a. Composition of assets and liabilities
b. Diversification and stability of liabilities: An FI would be more resilient
to stressed market liquidity conditions if its liabilities were derived from more
stable sources. In order to analyze the stability of l iabilities or funding sources
comprehensively, an FI needs to identify:
- liabilities that would stay with the FI under any circumstances;
- liabilities that run‐off gradually if problems arise; and
- liabilities that run‐off immediately at the first sign of problems.
Each FI needs to have explicit and prudent policies that ensure funding is not
highly concentrated with respect to:
- individual depositor;
- type of deposit instrument;
- market source of deposit; and
- term to maturity.
c. Dealing with liquidity disruptions: The FI should put in place a
strategy on how to deal with the potential for both temporary and long‐
term liquidity disruptions. The inter FI market can be important source of
liquidity. However, the strategy should take into account the fact that in
crisis situations access to inter FI market could be difficult as well as
costly.
The liquidity strategy must be documented in the liquidity policies, and
communicated throughout the FI. The strategy should be evaluated
periodically to ensure that it remains updated and effective.
 4.5 Liquidity Policies
Board of Directors should ensure that there are adequate policies to govern
liquidity risk management process. While specific details vary across
institutions according to the nature of their business, key elements of any
liquidity policy includes:
a. general liquidity strategy (short and long‐term), specific goals and objectives
in relation to liquidity risk management, process for strategy formulation and
the level it is approved within the institution;
b. roles and responsibilities of individuals performing liquidity risk
management functions, including structural balance sheet management, pricing,
marketing, contingency planning, management reporting, lines of authority and
responsibility for liquidity decisions;
c. liquidity risk management structure for identifying, monitoring, reporting and
reviewing the liquidity position;
d. liquidity risk management tools (including the types of liquidity limits and
ratios in place and rationale for establishing limits and ratios); and
e. contingency plan for handling liquidity crises.
 4.6 Procedures and Limits

FIs should establish appropriate procedures, processes and limits to

implement their liquidity policies. The procedural manual should explicitly
narrate the necessary operational steps and processes to execute the
relevant liquidity risk controls. The manual should be periodically
reviewed and updated to take into account new activities, changes in risk
management approaches and systems.
4.7 Liquidity Risk Management Process
An effective liquidity risk management process should include systems to
identify, measure, monitor and control its liquidity exposures.
Management should be able to accurately identify and quantify the
primary sources of an FI's liquidity risk in a timely manner. To properly
identify the sources, management should understand both existing as well
as future risk that the FI can be exposed to. Management should always be
alert for new sources of liquidity risk at both the transaction and portfolio
levels. Key elements of an effective risk management process should have
an efficient MIS to measure, monitor and control existing and probable
liquidity risks and report them to senior management and the board of
directors.
4.8 Measurement of Liquidity Risk
FIs should institute systems that enable them to capture liquidity risk ahead of time, so that
appropriate remedial measures could be prompted to avoid any significant losses.
Contingency funding plans, maturity ladder, liquidity ratios and limits etc. are commonly
used as liquidity measurement and monitoring techniques that may be adopted by the FIs.
4.8.1 Contingency Funding Plans
In order to develop comprehensive liquidity risk management framework, FIs should have
plans in place to address stress scenarios. This is commonly known as Contingency
Funding Plan (CFP). CFP is a set of policies and procedures that serves as a blueprint for
an FI to meet its funding needs in a timely manner and at a reasonable cost.
Use of CFP for routine liquidity management
For the purpose of day‐to‐day liquidity risk management, integration of liquidity scenario
will ensure that the FI is best prepared to respond to an unexpected problem. In this sense,
a CFP is an extension of ongoing liquidity management and formalizes the objectives of
liquidity management by ensuring:
a. a reasonable amount of liquid assets are maintained;
b. measurement and projection of funding requirements during various scenarios; and
c. management of access to funding sources.
Use of CFP for emergency and distress environments
Liquidity crisis may emerge all on a sudden. In case of a sudden liquidity
stress, it is important for an FI to seem organized, candid, and efficient to
meet its obligations to the stakeholders. Since such a situation requires a
spontaneous action, FI that already has plans to deal with such situation
can address the liquidity problem more efficiently and effectively.
Scope of CFP
The sophistication of a CFP depends upon the size, nature, and complexity
of business, risk exposure, and organizational structure. On the outset, the
CFP should anticipate all the funding and liquidity needs of an FI by:
a. analyzing and making quantitative projections of all significant on and
off balance sheet funds;
b. considering funds flows and their related effects;
c. matching potential cash flow sources and uses of funds; and
d. establishing indicators that alert management to a predetermined level
of potential risks.
 4.8.2 Maturity Ladder
FIs may utilize flow measures to determine their cash position. A maturity ladder
estimates an FI's cash inflows and outflows and thus net deficit or surplus (gap),
both on a day‐to‐day basis and over a series of specified time periods.
FIs need to focus on the maturity of its assets and liabilities in different tenors.
Mismatch accompanied by liquidity risk and excessive longer tenor lending
against shorter‐term borrowing can put an FI's balance sheet in a very critical and
risky position. FIs should use following time buckets for preparing their
Structural Liquidity Statement:
1. day to 30 days 5. Over 1 year to 3 years
2. Over 1 month to 3 months 6. Over 3 years to 5 years
3. Over 3 months to 6 months 7. Over 5 years
4. Over 6 months to 1 year
The number of time frames in a maturity ladder is of significant importance and
up to some extent depends upon the nature of FI's liabilities or sources of funds.
FIs, that relies on short term funding, will concentrate primarily on managing
liquidity on very short term.
However, other FIs might actively manage their net funding requirement over
a slightly longer period. In the short term, an FI's flow of funds could be
estimated more accurately and also such estimates are of more importance
immediately.
FIs need to monitor the gap on periodic basis (at least once in a month in
ALCO meeting). Moreover, FIs should monitor the gap on short term bucket
more prudently. While making an estimate of cash flows, the following
aspects need to be considered:
a. the funding requirement arising out of off‐ balance sheet commitments also
need to be accounted for;
b. many cash flows associated with various products are influenced by interest
rates or customer behavior. FIs need to take into account behavioral aspects
along with contractual maturity. In this respect past experiences could give
important guidance to make any assumption;
c. some cash flows may be seasonal or cyclical; and
d. management should also consider increases or decreases in liquidity that
typically occur during various phases of an economic cycle.
 4.8.3 Liquidity Ratios and Limits
FIs may use a variety of ratios to quantify liquidity. These ratios can also
be used to create limits for liquidity management. However, such ratios
would be meaningless unless used regularly and interpreted considering
qualitative factors. To the extent that any asset‐liability management
decisions are based on financial ratios, an FI's asset‐liability managers
should understand how a ratio is constructed, the range of alternative
information that can be placed in the numerator or denominator, and the
scope of conclusions that can be drawn from ratios.
Examples of ratios and limits that can be used are:
a. Cash flow ratios and limits:
b. Liability concentration ratios and limits
c. Loan to Fund ratio
d. Other Balance Sheet Ratios