Question

Liquidity is a financial institution's ability to meet its cash and collateral obligations without sustaining losses.

• Discuss why the degree of liquidity risk is different for different types of financial institutions (e.g., retail banks, life insurance companies, hedge funds).
• Discuss some of the risk management practices for liquidity risk.

Answer 1

Depository Institutions Are The Fis Most Exposed To Liquidity Risk. Mutual Funds, Pension Funds, And Pc Insurance Companies Are The Least Exposed. In The Middle Are Life Insurance Companies.

Liquidity Risk Occurs Because Of Situations That Develop From Economic And Financial Transactions That Are Reflected On Either The Asset Side Of The Balance Sheet Or The Liability Side Of The Balance Sheet Of An Fi. Asset-Side Risk Arises From Transaction That Result In A Transfer Of Cash To Some Other Asset, Such As The Exercise Of A Loan Commitment Or A Line Of Credit. Liability-Side Risk Arises From Transactions Whereby A Creditor, Depositor, Or Other Claim Holder Demands Cash In Exchange For The Claim. The Withdrawal Of Funds From A Bank Is An Example Of Such A Transaction.

1. Identify Liquidity Risks Early

A Liquidity Deficit At Even A Single Branch Or Institution Has System-Wide Repercussions, So It’s Paramount That Your Bank Be Prepared Before A Shortfall Occurs. This Means Your Bank Needs To Have A Rigorous Process For Identifying And Measuring Liquidity Risk.

2. Monitor & Control Liquidity Regularly

Once You’ve Identified And Forecasted Your Bank’s Liquidity Risk, You Need To Actively Monitor And Control Any Risk Exposures Or Funding Needs. Depending On The Size And Scope Of Your Bank, This Monitoring Needs To Account For Multiple Legal Entities, Business Lines And International Currencies. Of Course, You Must Also Remember To Account For Any Banking Compliance Regulations That Might Limit The Transferability Of Your Liquid Assets.

3. Conduct Scheduled Stress Tests

Just Like Any Professional Facility Must Practice For Fire Drills Or Emergency Procedures, Your Bank Needs To Conduct Regular Financial Stress Tests To Anticipate Different Potential Liquidity Shortfalls. Your Stress Tests Should Include Both Short-Term And Long-Term Scenarios That Identify Sources Of Liquidity Strain And That Ensure All Exposures Align With Your Established Liquidity Risk Tolerance.

4. Create A Contingency Plan

Using The Results Of Your Stress Tests, Adjust Your Liquidity Risk Management Strategies Accordingly. Then, Use These New Policies And Positions To Develop A Formal Contingency Funding Plan (Cfp) That Clearly Articulates Your Bank’s Plan For Overcoming Liquidity Shortfalls In Various Emergency Situations.

Some Of The Issues That Need To Be Kept In View While Managing Liquidity Include

(i)               The Extent Of Operational Liquidity, Reserve Liquidity And Contingency Liquidity That Are Required

(ii)             The Impact Of Changes In The Market Or Economic Condition On The Liquidity Needs

(iii)          The Availability, Accessibility And Cost Of Liquidity

(iv)           The Existence Of Early Warning Systems To Facilitate Prompt Action Prior To Surfacing Of The Problem And

(v)             The Efficacy Of The Processes In Place To Ensure Successful Execution Of The Solutions In Times Of Need.