Liquidity refers to the bank’s ability to meet its obligation as they become due. Liquidity management includes the ability of matching the liabilities with the assets of the banks. Banks should have an adequate system for measuring, monitoring, and controlling liquidity risk.
The objective of liquidity management is to ensure that the bank has sufficient funds to meet its contractual and regulatory financial obligations.
There are three types of liquidity risks:-
Funding Risk: It depends on the perception of the market and credit standing of the
Asset Liquidity Risk: Liquidity risk arises when maturities of assets exceed those of liabilities
Interest Rate Risk: If the rate of interest increase the value of long-duration assets will decline more than short-duration assets and asset sales would involve losses.
Factors affecting liquidity management in banks
Statutory requirements: such as CAR, SLR etc. required to maintain liquidity
Banking Habits of the people: individual depends more on cash transactions.
Monetary transactions: Higher monetary transaction higher liquidity
Overextension of credit: over lending requires high liquidity demand
Higher level of NPA (Non- performing assets): leads to decrease liquidity
Lack of appropriate liquidity policy: lead difficulty in managing liquidity
Poor Asset Quality: lead to decrease difficulty in selling the asset.
Reliance on few wholesale depositors: decrease in liquids funds in the future.
Deposit concentrations: focus on only one side of areas for funds necessary
Decline Earnings: leads to decrease in liquid funds
Important points for liquidity management in banks
Formulating liquidity policies and framework: liquidity policies and framework will support operational efficiency
Determining sufficient capital: helps in mitigating various risks
Improving cash Forecasting: effective planning regarding cash requirements
Identifying liquidity: It involves understanding the balances and positions of the institution on an enterprise-wide level.
Managing liquidity: involves supporting liquidity for revenue-generating activities.
Evaluate financial market: helps in analyzing markets risks and capital levels.
Establish clear lines of reporting: helps in monitoring reporting risk exposures.
Establish strong internal control: involves in analyzing liquidity position
Establish Strong management information: establishing effective communication
Ensure strong compliance: focus on acts, laws, regulations and internal policies
Regular review of policies: reviewing their policies and procedures for better liquidity
Uses tools of liquidity management:
Ratio Approach: such as CRR, SLR etc.
Liquidity Profile: refer to classification of total assets and total liabilities into different time interval
Stress Testing and Monitoring: assess the shocks effects on capital adequacy ratio profitability position and credit portfolio.
Principles of Liquidity Management
1. Banks must develop a structure for liquidity management
2. Banks must measure and monitor net funding requirements
3. Banks should manage market access
4. Banks should have contingency plans: for handling liquidity crises
5. Banks should manage their foreign currency Liabilities: Banks should have a measurement, monitoring, and control system for its liquidity positions.