Study On Liquidity Risk Management In Banks Finance Essay

Liquidity hazard is plays a critical function as compared to recognition, market and operational hazards due to its nature of intensifying with other hazards. An effectual hazard direction frame work is therefore required to for a robust liquidness hazard direction system in a bank. Effective Asset – liability direction, Daily Analysis of Cash influxs and escapes and emphasis testing will assist in this.

Cardinal rules for sound Liquidity Risk Management – Basle Principles

Basel Committee ‘s New Guidelines

In visible radiation of the state of affairss from the market disturbance The Basel Committee on

Banking Supervision ( BCBS ) late revised the counsel published in 2000. The

revised rules are intended towards set uping a sound frame work for liquidness

hazard direction.

Basel Principle 1

“ A bank is responsible for the sound direction of liquidness hazard. A bank should set up a robust liquidness hazard direction model that ensures it maintains sufficient liquidness, including a shock absorber of unencumbered, high quality liquid assets, to defy a scope of emphasis events, including those affecting the loss or damage of both unbarred and secured support beginnings. Supervisors should measure the adequateness of both a bank ‘s liquidness hazard direction model and its liquidness place and should take prompt action if a bank is lacking in either country in order to protect depositors and to restrict possible harm to the fiscal system ” – Basel Principle

The hazard direction frame work established by a bank should be robust and good

integrated to the bank ‘s hazard direction procedure. The frame work should be built in

such a manner that the bank should be able to pull off handily the short – term

liquidness & A ; long term liquidness duties. The basic focal point of the hazard direction

model should be to do certain that the bank keep sufficient liquidness shock absorber

which will enable them to confront the liquidness emphasis scenarios. The bank should be

conservative while doing premises sing the rating of assets during

market emphasis. The market emphasis should besides non take to compromise in the dependability

of liquidness hazard direction.

Administration of Liquidity Risk Management:

Basel Principle 2, 3 and 4 references the factors that need to be taken in to consideration by the senior direction and to be considered by the supervisors while measuring the liquidness tolerance.

As per Basel Principle 2, The board of managers is the determination shaper sing the

hazard tolerance of the bank and they need to keep the hazard tolerance taking in to

consideration the hazard appetency, fiscal place and support capableness of the bank

and should follow with the concern scheme of the organisation.

As per Basel Principle 3, The senior direction should take into consideration the

plus liability place, the handiness of funding resources ; pull offing liquidness in

different currencies, inter-day & A ; intra -day liquidness direction and the

premises on the tradability of assets. The scheme should be appropriate for the

market, should follow with the legal constructions of the market it operates.

There are assorted ways in which a bank can pull off its liquidness hazard tolerance.

Whatever methods a bank adopts they should guarantee that the liquidness maintained

strongly during normal concern yearss so that the bank has the capableness to defy

a longer emphasis period which may individual organisation specific or market particular.

The strategic policies should be reviewed yearly and should do certain these

schemes are brought in to pattern the day-to-day banking concern by doing them

approved policies & A ; processs. The direction should guarantee that they closely

watch the current market scenario and the possible alterations in the market to enable

them make the necessary alterations in the liquidness hazard tolerance policies. The

direction should besides guarantee that effectual CFP, stress trial and liquidness

shock absorbers are maintained in the scheme developed by them.

As per Basel Principle 4, the hazard tolerance scheme developed by the senior

direction should include quantification of liquidness cost, benefits and hazards

embedded in all concern activities which might non hold direct impact on balance-

sheet. This helps to bank to plan the scheme with appropriate ascriptions to each

of these harmonizing to their comparative peril.

Early on warning signal of unacceptable hazard tolerance

Identifying the outgrowth of hazard and, exposures in the liquidness hazard place at

the right clip will assist the bank to come out with processs and policies to extenuate

such hazards. Banks need to hold early warning indexs which will enable the Bankss

to analyze the outgrowth of negative tendencies.

As per Base II, Early warning indexs can be qualitative or quantitative in nature and may include but are non limited to:

aˆ? rapid plus growing, particularly when funded with potentially volatile liabilities

aˆ? turning concentrations in assets or liabilities

aˆ? additions in currency mismatches

aˆ? a lessening of leaden mean adulthood of liabilities

aˆ? perennial incidents of places nearing or transgressing internal or regulative


aˆ? negative tendencies or heightened hazard associated with a peculiar merchandise line, such as

lifting delinquencies

aˆ? important impairment in the bank ‘s net incomes, plus quality, and overall fiscal

aˆ? Negative promotion

aˆ? recognition evaluation downgrade

aˆ? Stock monetary value diminutions or lifting debt costs

aˆ? Widening debt or credit-default-swap spreads

aˆ? Rising wholesale or retail support costs

aˆ? Counterparties that begin bespeaking or request extra collateral for recognition

exposures or that resist come ining into new minutess

aˆ? Correspondent Bankss that eliminate or decrease their recognition lines

aˆ? Increasing retail sedimentation escapes

aˆ? Increasing salvations of Cadmiums before adulthood

aˆ? Difficulty accessing longer-term support

aˆ? Difficulty puting short-run liabilities ( eg commercial paper ) – published in rules of sound

liquidness hazard direction

Measurement and Evaluation of liquidness hazard

To command hazard efficaciously, a thorough analysis and measuring of hazard demands to be

done. This provides the direction a clear apprehension of a bank ‘s current

scenario and in make up one’s minding the future class of action.

Basel rule 5 negotiations of the measuring and rating or liquidness hazard.

Principle 5

‘A bank should hold a sound procedure for identifying, mensurating, monitoring and commanding liquidness hazard. This procedure should include a robust model for comprehensively projecting hard currency flows originating from assets, liabilities and off-balance sheet points over an appropriate set of clip skylines ‘ – Basel Principle 5

A bank should hold the mechanisms to mensurate and analyse the possible hard currency

flows of assets and liabilities during the normal concern conditions and besides during

the emphasis. The bank should guarantee that factors like inter-day and intra-day liquidness

place, funding capablenesss over a short, medium and long term are analysed

The subordinates and subdivisions in the legal power in which a bank is active, should

have good defined liquidness hazard policies which is relevant to the country. The bank should

analyse every major on and off- balance sheet place, including the contingent

exposures that might impact the bank ‘s liquidness hazard.

The interaction between the support liquidness hazard and market liquidness hazard should be

analysed and the exposure should besides be analyzed. Liquidity obtained from capital

markets will be more volatile as compared to the retail sedimentations. Illiquidity spirals

might besides stem up from this state of affairs due to Bankss stock stacking liquidness non will to

lend in the interbank market because of the apprehensivenesss about the hereafter market

and the ability to raise speedy financess in the inauspicious state of affairss.

The interactions between liquidness hazard and other fiscal and runing hazards like

involvement rate, reputational hazards, legal hazard etc which will impact the bank ‘s liquidness

profile demand to be considered. Since these hazards are inter linked, liquidness hazard can

arise from the jobs linked to other hazards.

Based on the treatments, we had from assorted senior directors that manage liquidness hazard within an organisation the undermentioned simple process is usually adopted by Bankss

Referred from

The process starts with garnering informations of hard currency influxs and escapes. After the information

is calculated, net support demands ( and accordingly funding spreads or

excesss ) is can be calculated and mapped to a adulthood ladder. While making this

the contingent liabilities need to be taken in to account. It is of import to cipher

contingent liabilities as it helps to acquire a clearer image and should besides be a portion of

net support demand.

An estimation of future concern developments, recognition lines should besides analysed so

the provided necessary commissariats for the same. Especially incase of recognition lines, the

recognition appetency of nostro Bankss should besides be taken into consideration.

Desired cost/benefit proposition to liquidness hazard direction

Referred from gtnews

The distribution in the above diagram is the figure of minutess

done to cover short places. The coveted country where maximal minutess should

take topographic point is in the green country. The xanthous country is lesser coveted country and the ruddy

country demand to be avoided. The bulk of minutess should of class happen in the

desired green country and the ruddy country must decidedly be avoided.

Below is the pictural representation of the procedure advised by Basel Committee to

manage liquidness.

This diagram negotiations about the lower limit capitals than Bankss must

manage to keep to cover unexpected losingss

Basel II capital demands are set to cover for major banking hazards

In February 2008 the Basel Committee on Banking Supervision published

Liquidity Risk Management and Supervisory Challenges set uping 17

rules for pull offing and oversing liquidness hazard in a figure of cardinal countries, such


the importance of set uping a liquidness hazard tolerance ;

the care of an equal degree of liquidness, including through a shock absorber of

liquid assets ;

the necessity of apportioning liquidness costs, benefits and hazards to all important

concern activities ;

the designation and measuring of the full scope of liquidness hazards, including

contingent liquidness hazards ;

the design and usage of terrible emphasis trial scenarios ;

the demand for a robust and operational eventuality support program ;

the direction of intraday liquidness hazard and collateral ; and

public revelation in advancing market subject. – published in Liquidity Risk Management

and Supervisory Challenges

Public Disclosures

Eventuality Funding Plan

Eventuality Funding Plan, normally known as CFP is set of policies designed to

move a guideline for a bank to assist it run into the support demand at a sensible

cost. An effectual CFP should be able to supply a model for liquidness hazard

direction by analysing both short and long -term support demands and should

gauge the alterations that can go on due to recognition event or a liquidness event and

this in bend help the bank prepare better for the normal and stress period.

Scope of CFP

CFP should be able to analyse all the liquidness needs of the bank by doing

projections of all on balancesheet and off-balancesheet fund flows and the effects

related to these, possible beginning and usage of financess should be matched.

CFP should besides be able to project the impermanent and long-run support place and

should place and rank all beginnings of financess by penchant such as:

A ) Reducing Assetss

B ) Amendments in liability construction

C ) Other options used for commanding balance sheet alterations

Liquidity Ratios and Limits

Assorted ratios are used by Bankss to quantify liquidness and to put bounds for liquidness hazard

direction. The assorted ratios used are Cash Flow ratios, Liability concentration

Ratios and other balance sheet Ratios such as entire loans/total sedimentations, Entire

loans/total equity capital, borrowed funds/total assets.

Cash Flow Ratios and bounds:

This ratio computation helps to mensurate and command the adulthood of liabilities during a

certain period of clip and hence, regulations out one of most serious liquidness hazard which is

the inability to turn over over maturating liability.

Liability concentration Ratios and bounds:

This ratio helps the bank to analyse and forestall from acquiring concentrated on few

client. The bounds are normally calculated as per centums or as absolute sum.

Other Balance Sheet Ratios:

Assorted other Ratios such as Entire loans/total sedimentations, entire loans/total

equity capital, borrowed funds/total assets etc are calculated to pull off the bing

and the possible support degrees.

Stress Testing:

As per Basel Principle 10, stress trial demands to be conducted for organisation particular

and market scenarios. The stress trial consequences should be used by the Bankss to

explicate the liquidness hazard direction policies and processs. The stress trial

consequence besides plays a critical function in explicating the CFP.

The edification of the emphasis proving depends on the size, activities, nature of

concern and the liquidness hazard exposure. Analyzes these will assist the bank to

measure the impact these can hold on liquidness place of the organisation.

The senior direction should affect in the emphasis proving procedure as this will

enable them to assist do schemes which will see the challenging emphasis

scenarios even when liquidness is sufficiently available.

Another most of import factor to be taken into consideration is the false

behavior of the counter parties in the event of market emphasis and how it would impact

the hard currency flow.

How have UAE Bankss geared themselves to pull off liquidness hazard direction

Based on the treatments with directors in recognition & A ; hazard admin of assorted taking

Bankss in UAE, we concluded that taking Bankss in UAE have implemented Basel II

agreement and the other Bankss are besides in the procedure of implementing the same.

Basel II is on the top of UAE Banks agenda due to both regulative demand and competitory force per unit area

Basel II rules are based on 3 pillars:

Minimum capital Requirement – Pillar I

Supervisory Review – Pillar II

Market Discipline – Pillar Three

Minimum capital demand is calculated in such a manner that it reflects the recognition

evaluations of the counter parties.

Minimal Capital Requirements for recognition hazard:

Minimum Capital = 8 % * RWA= EAD * LGDO*f ( PD, M )

EAD = Exposure At Default

LGD = Loss Given Default

degree Fahrenheit ( PD, M ) is a map given by the regulator that depends on the plus category

PD = Probability of Default

M= Effective Maturity

Pillar II: Supervisory Review – 4 Basic Principles:

Market Discipline – Pillar 3

Under Basel II attack there are three methods for recognition hazard: A ) Standardized Approach B ) The Internal Ratings based C ) Advanced IRB attack

Standardized attack takes in to consideration the recognition evaluation of the borrower

instead than concentrating all commercial loans in 100 % hazard weight basket. The recognition

evaluation is assigned by an authorised external evaluation bureau that meets the

demands as mentioned in the agreement.

The below is the chart correlates the recognition evaluation and hazard weight for rated exposures

Recognition Rating

AAA to AA-

A+ to A-

BBB+ to BB-

Below BB-


Hazard Weight

20 %

50 %

100 %

150 %

100 %

Recognition Risk Extenuation:

In Standardized attack, the hazard extenuation techniques used are more the followers


A bank can merely utilize sacking merely it has a legal sentiment corroborating that sacking will

work as its systems allow it to cipher the net exposure


The most of import factor in instance of collateral is that whether the bank can obtain

the value for collateral, the understanding is lawfully enforceable.

Guarantees and Credit Derived functions

CBUAE will allow the usage of warrants or recognition derived functions provided these are:





Basel II Credit hazard – Internal Ratings based attack ( IRB )

As compared to Standardized attack, IRB is a more complicated agreement for

execution, nevertheless based on the treatments with assorted serious directors,

we have concluded that most of the prima Bankss are in the procedure of

implementing IRB.

To be IRB compliant the modification establishments must hold evaluation system with the following 4 cardinal constituents:

IRB Qualification: Rating Assignment

Two – Dimensional Rating System

Two dimensional Rating System – Obligor and loss badness evaluation

Default Definition ( hard-pressed Restructuring, non – accrual position )

Discrete Obligor evaluation

Rank ordination of hazard and loss badness and assignment of PD/LGD parametric quantities

Minimum Obligor evaluation coarseness

LGDs are stress conditions LGDs

Time lines Of Evaluations

Annual Update at least is required

Validation Procedure

Ensures long- run truth of PD/LGD estimations

Developmental Evidence ( logic and analysis )

Ongoing Validation: Process confirmation & A ; Benchmarking against internal/external Datas

IRB Qualification: IRB Parameters

Four phases of Qualification Process

Obtaining Reference Data

Estimating statistical relationship between mention informations and PD/LGD/EAD

Function of Portfolio informations to cite informations

Using relationship estimated for mention informations to existent portfolio informations

Determining chance of Default

5 twelvemonth sample informations

Obligor preferred or grade function often updated

Application of PD appraisal ( Potential accommodations )

Estimates of default rates represent long tally norm of mean one twelvemonth default rates

Determining Loss given default

7 old ages data available to cipher economic loss

Consistent default definition

Grouping LEQ ( Loan equivalent exposures ) of default installations ( eg. Collateral, insurance and adulthood )

Determining Exposure at default

Need to find loan tantamount exposures based on driver analysis

Cohort method and default- leaden period

Fixed skyline method

IRB Qualification: Data Parameters

Life Cycle Tracking

All relevant informations back uping evaluation, front – terminal proof, back- testing and parametric quantity estimations must be collected, analyzed and archived, eg, factors used for evaluations, recoveries.

Rating assignment informations

Institutions must capture all important quantitative and qualitative factors used to delegate obligor and loss badness evaluations and present them to the informations warehouse

Data Collection

Must be sufficient in deepness, range and dependability

To formalize IRB system processes and parametric quantities

Develop PD/LGD/EAD parametric quantities

Apply evaluations system betterments historically

Support pillar III revelation

Data Quality and Integrity

Documentation of informations bringing procedure, informations storage/warehousing

IRB Qualification: Oversight and control mechanisms

Use of Internal Rating

Internal evaluations and default loss estimations must play an indispensable function in recognition blessing and hazard direction procedure

Use of Models

All relevant and material information, including those which are outside the range of theoretical account, should be taken into consideration while ciphering recognition hazard

Integrity of evaluation

Rating assignments and periodic evaluation reappraisals must be completed or approved by a party that does non stand to profit from the extension of recognition


Banks must clearly advert the state of affairss in which bank officers may overrule the end products of the evaluation procedure. Bank ‘s guidelines must include identifying forces that are responsible for these overrides

Corporate administration and inadvertence

Senior direction must hold a clear apprehension of the evaluation and appraisal procedure


Ongoing reappraisal of evaluation system public presentation by independent map

The below diagram high spots some of the benefits which the taking Bankss of UAE expect to accomplish and they believe that these benefits can be captured phase wise which is mentioned below.

Capturing the benefits comes in phases

One of the taking Bankss in UAE, which successfully implemented Basel II andfollows IRB attack feels that Basel II is the first measure to put on the line direction excellence.