Liquidity Management

Banks are required to honour withdrawals from Deposits. Also the banks are supposed to
disburse loans in time. Liquidity is needed to meet both these requirements. In other words,
liquidity is the ability to accommodate decrease in liability as well as funding of increase in
assets.
Functions of Liquidity Management:
1. It defines market place of bank.
2. It enables banks to meet prior loan commitments.
3. It enables the banks to avoid unprofitable sale of assets.
4. It lowers size of default risk premium.
Liquidity Mismanage may lead to the following:
 It declines earnings.
 It increases NPAs.
 It results in downgrading of rating.
Factors affecting Liquidity
Liquidity is affected by the following:
1. Less profits leads to less liquidity
2. Rise in NPAs means less liquidity
3. Deposit concentration in Term Deposits may lead to less liquidity
4. More taxes means less liquidity.
Types of Liquidity Risks
1. Funding Risk: Decrease in deposits due of bad reputation or loss of confidence.
2. Time Risk:Instalments of loan are not forthcoming in time.
3. Call Risk: Non-fund based credit facilities converted into Fund based. Crystallization of
Contingent liabilities like LC/LG turning into Fund Based Loans.
4. Embedded Risk: Adverse movement of Interest Rate may result into pre-payment of
CC/DL and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also
result into reduced NII. This is called Embedded Risk.
How to manage Liquidity Risk?
1. Developing an organizational structure.
2. Setting of Tolerance level limits.
 Limit of cash flow mismatches for tomorrow, next week, next month or next year.
 Limit of Loan to Deposit Ratio
 Limit of Loan to Capital ratio.
Mismatch level in 1-14 days bucket and 15-88 days bucket should remain about 80% of cash
flow in the particular period. To manage liquidity and remain solvent by maintaining short term
gap up to 1 year should be around 15% .
Measurement of Liquidity Risks: Liquidity Risk can be measured in any of the two ways:
1. Stock Approach
2. Flow Approach


Stock Approach
Following ratios are calculated to measure Liquidity Gap:
Better it is from Liquidity Point of view
Ratio of Core Deposits to Total Assets More the ratio, better it is
Net Loans to Total Deposits Lower ratio is better
Time deposits to Total Deposits Higher ratio is better
Volatile Liabilities to Total Assets (Market
borrowings are volatile liabilities
Lower ratio is better
Short Term Liabilities to Liquid Assets Lower ratio is better.
Liquid Assets to Total Assets Higher ratio is better.
Short Term Liabilities to Total assets Lower is desirable
Prime Assets to Total Assets (Prime assets
are Cash, Balance with banks etc.
Higher is better
Market Liabilities to Total assets (Market
liabilities are Money Market borrowings, Repo
and Inter-bank liabilities
Lower is better
Flow Approach: It has 3 major dimensions:
1. Measuring and managing net funding requirements through
 Maturity ladder
 General Market conditions
 Bank specific crisis.
 General Market crisis.
2. Measuring Liquidity over chosen time frames.
3. Contingency Planning
RBI guidelines for maturity Buckets:
All Assets and Liabilities are classified into 10 maturity buckets:
1. Tomorrow
2. 2-7 Days
3. 8-14 Days
4. 15-28 Days
5. 29 Days to 3M
6. 3M to 6M
7. 6m to 1 Year
8. 1-3 Years
9. 3-5 Years
10. Over 5 years