Liquidity Management Functions, Benefits, Risk

Liquidity Management

Table of Contents:-

  • What is liquidity management?
  • Need for Liquidity Management
  • Functions of Liquidity Management
  • Benefits of Liquidity Management
  • What is liquidity
  • Liquidity Risk
  • Sources of Liquidity Risk

What is Liquidity Management?

Liquidity management is a systematic and strategic approach which businesses, individuals, or financial institutions use to ensure that they have sufficient funds or assets available which can be easily and immediately converted to cash to meet their short-term financial commitments.

The objective of liquidity management is to ensure the business always has cash available when needed. This can be achieved by managing the company’s liquidity as efficiently and effectively as possible. For companies that operate in multiple currencies and countries and hold accounts with many different financial institutions, managing liquidity can be particularly complex. Effective bank liquidity management means employing a centralized process to obtain full visibility over the company’s liquidity. Efficiency, meanwhile, can be achieved by using new methods to enhance connectivity with sources of information about the company’s cash.

An important aspect of liquidity management involves the use of techniques such as cash flow modelling. This can provide the corporate treasury team, CFO, and finance team with full visibility over the company’s liquidity. It is also important to have complete visibility over the lines of credit available for short-term borrowing, including balances and limits; otherwise, companies won’t be able to know how much money can be drawn from a particular line of credit. Liquidity management also includes managing the risk that the company may not have enough liquidity available to meet its upcoming obligations on time. This is a very real risk; even a profitable company can fail if it lacks the cash needed to meet its commitments.

Need for Liquidity Management

The need for liquidity management arises due to the following reasons:

1) The existing level of control over liquidity and cashflows is no longer sufficient.

2) Liquidity management procedures are inadequate and restrictions are obsolete and prevent business from going forward.

3) Liquidity contingency plans are not realistic in the current market conditions.

4) Fair value and maturity of assets as well as conditional liabilities that could materialize in the current environment need to be identified. Quick decision making often fails to follow the even faster economic environment.

5) The additional volume of liquid reserves needs to be attracted to close the liquidity gap.

Functions of Liquidity Management

The functions of liquidity management are as follows:

1) Analyze actual liquidity and evaluate liquidity risk.

2) Develop and improve liquidity contingency plans under the crisis conditions.

3) Design scenarios and stress tests to analyze the efficiency of policies and models for liquidity contingency procedures under crisis conditions.

4) Assess the relevance and efficiency of models used to analyze assets and liabilities.

5) Develop reporting systems within the asset and liability management framework, including a system for monitoring liquidity risk.

6) Develop policies and procedures for liquidity risk management.

7) Develop a methodology for evaluating the deposit base and the potential growth of accounts receivable due to realized contingencies.

8) Test the current IT system architecture and evaluate its efficiency in maintaining procedures for assets and Liability management.

9) Analyze actual liquidity and the system of limits to make recommendations for necessary changes.

Benefits of Liquidity Management

The benefits of liquidity management are as follows:

1) Consistent asset and liability management standards throughout the company.

2) Implementation of the standard industry practices.

3) Formalized policies and procedures.

4) Increased transparency in identifying liquidity risk for the whole company.

5) Automation of report preparation and the collection of analytical data for asset and liability management.

6) Enhanced effectiveness and accuracy in evaluating liquidity risk, communicating this to company management as well as risk testing and modelling.

7) Independent analysis of the current assets and liabilities portfolio.

8) Accurate segregation of duties and responsibilities within the liquidity management unit and control over liquidity monitoring performed by the company’s management.

What is liquidity

Liquidity is essential in all banks to compensate for both expected and unforeseen fluctuations in the balance sheet while also providing funds for expansion.

The recent liquidity crisis faced by banks and financial institutions has brought to the fore, the need to review their existing liquidity management policies, practices, and procedures.

To monitor liquidity and funding, financial institutions need to have the capability and knowledge for regular liquidity risk management and reporting that measure, the potential impact of moderate risk and crises, and project sources and uses of funds. Sound short-term and long-term liquidity risk management is an integral component of a bank’s contingency funding plan, to prepare a bank for any significant funding crisis that could arise.

The economic downturn is affecting how financial institutions manage liquidity in several ways. It has particularly affected the liquidity of financial instrument portfolios, which now necessitate a comprehensive reassessment.

Liquidity Risk

Liquidity risks can arise from specific individual products or business lines, necessitating an overall framework for total liquidity management. Some of these risks can emerge from contingent commitments—whether contractual or non-contractual (where the reputational costs of not meeting that commitment are severe enough to make them effectively contractual). Credit counterparty risks and Liquidity risks are inherently interrelated, and liquidity risk can easily transform into solvency risk for an institution.

Sources of Liquidity Risk

The sources of liquidity risk for a bank are as follows:

1) Uncertain Account Activity

The nature of demand liabilities and advances in the form of cash credit and overdraft accounts is the second source of risk. These are accounts where cashflows are not contractually time-bound, leading to uncertainty in inflows and outflows. The bank has to predict the maturity profile of these accounts when allocating them to time buckets.

2) Intrinsic Mismatches

The management information system of a bank can easily identify a large mismatch in the contractual cashflows arising from existing business. While there may not be much uncertainty associated with the occurrence of the mismatch, the uncertainty linked to the bank’s ability to bridge this gap is a source of risk.

3) Credit and Interest Rate Risk

The default of counterparty lends further uncertainty to cashflows and is another source of liquidity risk. A problem loan will demonstrate irregular payments of principal and interest causing disturbance in cashflows. Movements in interest rates can result in dynamic changes in the portfolio due to interest rate sensitivity-driven early withdrawals and prepayments. A depositor holding a term deposit with lower interest rates might wish to take advantage of prevailing high-interest rates by exercising his early withdrawal option.

Interest and credit rate risks are also considered precursors to liquidity risk problems. Interest rate and credit risk weaken the financial intermediary, causing its sources of funding to shrink and causing it to borrow at higher rates, further aggravating its weak financial condition. These events can lead to liquidity problems characterized by default by the FI on contractual payments. This propels the financial institutions into a vicious cycle of poor and default performance.

4) Inadequate Funding Capability

All the above sources are connected to the forward payment structure, i.e., the profile of cash inflows and outflows in the future. A bank might also experience liquidity risk owing to the unavailability of liquid assets, rating downgrades leading to shrinkage of sources of funds or insufficient backup lines of funding, and sources unconnected to the forward payment structure.

5) Portfolio Dynamism

The growth dynamics of the bank’s portfolio both in terms of existing and new deals is the third major source of liquidity risk. This involves the alteration of existing deals that have otherwise contractually bound cashflows and the garnering of new deals. Existing term deposits can be altered through early withdrawal options while term loans face the possibility of alteration through prepayment. New deals can be classified into rollovers of existing maturing deals and fresh transactions.

Liquidity Management

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