Liquidity Functions of Banks

Liquidity Risk Funding risk – Liability maturity structure Timing risk – Reutilization of funds Call risk – Off-balance sheet obligations

Liquidity Management Reserve Bank of India Ability to efficiently accommodate deposit and other liability decreases as well as loan portfolio growth and the possible funding of off-balance sheet items Funding through deposits Liability side management Asset side management Managing off-balance sheet transactions

Liquidity Risk for Banks Bank faces a stagnant deposit portfolio while demand for loans and advances from corporate sector increases Or Bank is required to increase the asset base to meet its increased overheads Mismatch of the composition of assets and liabilities Short term liabilities are used to fund long term assets

Conflict in Liquidity Risk Management Pricing of assets and liabilities determines the short term problems in liquidity management for banks Balancing returns in relation to fund requirements is the core of liquidity management If liabilities are priced less (rate of interest on a deposit in a bank is lower than that of other peer level banks), there will be more outflow, assuming assets (loans and advances, investment) remain at the same level

Conflict in Liquidity Risk Management If liabilities are priced low (rate of interest on bank deposit is lower than other banks), the bank will face shortage of inflow, assuming asset demand remains the same An ideal balance is to be maintained between the levels of liabilities and assets so as to avoid the liquidity trap

Focal Areas for Banks in Liquidity Management Composition of liabilities, particularly the level of demand liabilities (current accounts and saving bank accounts) in relation to term liabilities (fixed deposits) Build up of assets, particularly the level of term assets (term loans beyond 3 years and investments in long term securities to be held till maturity) in relation to short term assets net of non-performing assets (cash credit, overdrafts, demand loans)

Focal Areas for Banks in Liquidity Management Predominant area of operation Dominant customer profile of the bank Ownership of the bank (Government holding, Institutional holding, Public holding) Public image of the bank 8

Action Plan Realistically assess on an ongoing basis the likely inflow of deposits and likely demand for bank loans and also the bank’s own policy towards investment in securities Possibility of renewal of maturing liabilities (fixed deposits) and core deposits in current liabilities (current accounts, savings bank account) as also of revolving assets (cash credit, overdraft) Reliability of assets (recovery from borrowers on demand and sale of investment and other assets when necessary)

Action Plan Ability to utilize opportunities arising in the banking system Likelihood of a larger outflow of deposits may arise if the bank’s image is tarnished or a scam has occurred in a bank or there is a sudden change in the public perception Top priority to relationship with bank customers so as to build and maintain confidence in the bank

Action Plan Funding requirement of the bank to be assessed on a daily basis keeping in view likely future inflows and outflows Classifying assets and liabilities over the applicable time buckets Ability of the bank to function on a conservative basis to meet an adverse situation that may occur at any point of time

Action Plan Ability of the bank to maintain its investment in securities and avoid distress sale on account of liquidity crisis Ability of the bank to avoid high cost borrowing from the Reserve Bank and other market borrowings on a frequent basis 12

Managerial Actions in Liquidity Management Core activity Pricing of assets and liabilities Related problem Interest risk management

Tools for Liquidity Management Short term implications Long term implications

Short Term Implications Working Funds Approach Cash Flow Approach

Working Funds Approach Bank resources: Owned capital Deposits Volatile deposits (30 days) Vulnerable deposits (core / non-core) Core funds Float funds Transit funds Funds on issue of drafts / pay orders / cheques Full Liquidity Full Liquidity

Cash Flow Approach Estimation of anticipated deposit base Likely quantum of recycling of funds that have been lent (includes loan recovery of non performing assets) Assessment of quantum of maturity of deposits and withdrawals Likely amount of deployment in loans and advances or investments Computation of liquidity level for a specific period with a variance level of 10 to 15%

Long term Implications Asset Management Liquidity Management

Reserve Bank of India Guidelines on Liquidity Management Fortnightly statement of structural liquidity Fortnightly statement of short term (up to 90 days) dynamic liquidity

Statement of Structural Liquidity Statement on the basis of liabilities and assets on the last reporting Friday Time buckets on the residual maturity of each item of assets and liabilities

Time Buckets 1-14 days 15-28 days 29 days to 3 months Over 3 months to 6 months Over 6 months to 1 year Over 1 year to 3 years Over 3 years to 5 years Over 5 years

Short term Dynamic Liquidity Fortnightly statement of outflows and inflows of assets and liabilities for a period of 90 days. Time Buckets 1-14 days 15-28 days 29 days to 3 months Mismatch / cumulative mismatch as a percentage of the total outflows

RBI Format – Dynamic Liquidity 1-14 days 15-28 days 29-90 days A.Outflows Net increase in loans and advances Net increase in investments (i) Approved securities (ii) Money market instruments (other than treasury bills) (iii) Bonds/debentures/shares (iv) Others Inter-bank obligations Off-balance sheet items (repos, swaps, bills discounted) Others Total outflows

RBI Format – Dynamic Liquidity 1-14 days 15-28 days 29-90 days B. Inflows Net Cash position Net increase in deposits (less CRR obligations) Interest on investments Inter-bank claims Refinance eligibility (Export credit) Off-balance sheet items (reverse repos, swaps, bills discounted) Others Total inflows

RBI Format – Dynamic Liquidity 1-14 days 15-28 days 29-90 days C. Mismatch (B – A) D. Cumulative mismatch E. ( C) as a percentage to total outflows