Liquidity risk is the potential inability to meet the bank's liabilities as they become due. It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities. Measuring and managing liquidity needs are vital for effective operation of commercial banks. By assuring a bank's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing.

Analysis of liquidity risk involves the measurement of not only the liquidity position of the bank on an ongoing basis but also examining how funding requirements are likely to be affected under crisis scenarios. Net funding requirements are determined by analysing the bank's future cash flows based on assumptions of the future behaviour of assets and liabilities that are classified into specified time buckets and then calculating the cumulative net flows over the time frame for liquidity assessment.

Future cash flows are to be analysed under "what if" scenarios so as to assess any significant positive / negative liquidity swings that could occur on a day-to-day basis and under bank specific and general market crisis scenarios. Factors to be taken into consideration while determining liquidity of the bank's future stock of assets and liabilities include their potential marketability, the extent to which maturing assets /liability will be renewed, the acquisition of new assets / liability and the normal growth in asset / liability accounts.

Factors affecting the liquidity of assets and liabilities of the bank cannot always be forecast with precision. Hence they need to be reviewed frequently to determine their continuing validity, especially given the rapidity of change in financial markets.

The liquidity risk in banks manifest in different dimensions:

1. Funding Risk - need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

2. Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

3. Call Risk - due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.

The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia , should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting / reviewing, etc. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are Loans to Total Assets, Loans to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans, etc.

While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on projected future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the behavioural maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance analysis, at least, once in six months to validate the assumptions. The assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on / off-balance sheet items. Apart from the above cash flows, banks should also track the impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallised.

The difference between cash inflows and outflows in each time period, the excess or deficit of funds, becomes a starting point for a measure of a bank's future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits as detailed below to avoid liquidity crisis:

1. Cap on inter-bank borrowings, especially call borrowings

2. Purchased funds vis-à-vis liquid assets;

3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans;

4. Duration of liabilities and investment portfolio;

5. Maximum Cumulative Outflows across all time bands;

6. >Commitment Ratio - track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure

7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further, the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc.

The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to:

1. Seasonal pattern of deposits/loans;

2. Potential liquidity needs for meeting new loan demands, unavailed credit limits, potential deposit losses, investment obligations, statutory obligations, etc.

• All banks are required to produce a Contingency Funding Plan. These plans are to be approved by ALCO, submitted annually as part of the Liquidity and Capital Plan, and reviewed quarterly. The preparation and the implementation of the plan may be entrusted to the treasury.

• Contingency Funding Plans are liquidity stress tests designed to quantify the likely impact of an event on the balance sheet and the net potential cumulative gap over a 3-month period. The plan also evaluates the ability of the bank to withstand a prolonged adverse liquidity environment. At least two scenarios require testing: Scenario A, a local liquidity crisis, and Scenario B, where there is a nationwide name problem or a downgrade in the credit rating if the bank is publicly rated.

• The bank's contingency funding plans should reflect the funding needs of any bank managed mutual fund whose own Contingency Funding Plan indicates a need for funding from the bank.

• Reports of Contingency Funding plans should be performed at least quarterly and reported to ALCO.

• If a Contingency Funding plan results in a funding gap within a 3-month time frame, the ALCO must establish an action plan to address this situation. The Risk Management Committee should approve the action plan.

• At a minimum, Contingency Funding plans under each scenario must consider the impact of accelerated runoff of Large Funds Providers.

• The plans must consider the impact of a progressive, tiered deterioration, as well as sudden, drastic events.

• Balance sheet actions and incremental sources of funding should be dimensioned with sources, time frame and incremental marginal cost and included in the Contingency Funding plans for each scenario.

• Assumptions underlying the Contingency Funding plans, consistent with each scenario, must be reviewed and approved by ALCO.

• The Chief Executive / Chairman must be advised as soon as a decision has been made to activate or implement a Contingency Funding Plan. Either the Chief Executive or the Risk Management Committee may call for implementation of a Contingency Funding Plan.

• The ALCO will implement the Contingency Funding Plan, amending it with the approval of the Risk Management Committee, where necessary, to meet changing conditions; daily reports are to be submitted to the Treasury Head, comparing actual cashflows with the assumptions of the Contingency Funding Plan.

For banks with an international presence, the treatment of assets and liabilities in multiple currencies adds a layer of complexity to liquidity management for two reasons. First, banks are often less well known to liability holders in foreign currency markets. Therefore, in the event of market concerns, especially if they relate to a bank's domestic operating environment, these liability holders may not be able to distinguish rumour from fact as well or as quickly as domestic currency customers. Second, in the event of a disturbance, a bank may not always be able to mobilise domestic liquidity and the necessary foreign exchange transactions in sufficient time to meet foreign currency funding requirements. These issues are particularly important for banks with positions in currencies for which the foreign exchange market is not highly liquid in all conditions.

Banks should, therefore, have a measurement, monitoring and control system for liquidity positions in the major currencies in which it is active. In addition to assessing its aggregate foreign currency liquidity needs and the acceptable mismatch in combination with its domestic currency commitments, a bank should also undertake separate analysis of its strategy for each currency individually.

When dealing in foreign currencies, a bank is exposed to the risk that a sudden change in foreign exchange rates or market liquidity, or both, could sharply widen the liquidity mismatches being run. These shifts in market sentiment might result either from domestically generated factors or from contagion effects of developments in other countries. In either event, a bank may find that the size of its foreign currency funding gap has increased. Moreover, foreign currency assets may be impaired, especially where borrowers have not hedged foreign currency risk adequately. The Asian crisis of the late 1990s demonstrated the importance of banks closely managing their foreign currency liquidity on a day-to-day basis.

The particular issues to be addressed in managing foreign currency liquidity will depend on the nature of the bank's business. For some banks, the use of foreign currency deposits and short-term credit lines to fund domestic currency assets will be the main area of vulnerability, while for others it may be the funding of foreign currency assets with domestic currency. As with overall liquidity risk management, foreign currency liquidity should be analysed under various scenarios, including stressful conditions.