Every business enterprise is initiated with the main aim of gaining investment rewards. However, such businesses may encounter a given degree of uncertainties during their operation thereby lowering the actual returns way below the expected financial returns. The probabilities of such occurrences constitute the financial risks in the business. There are a variety of financial risks including capital risk where the amount of capital invested may be lost, Currency risk where currency shifts may influence the value since the assets are invested in a different currency, credit risk which entails the failure of a borrower to settle the debt as promised, Liquidity risk where a company has insufficient cash to meet its expenses, and solvency risks where the company’s liability exceeds its assets and therefore unable to pay its debts among other financial risks.
Investments are always installed in the marketplace depending on the available opportunities in such areas. Business owners may therefore invest in a variety of ventures given the prevailing favorable business environment. However, some forms of investment may take time to sell either because the capacity of the market is small or certain ventures such as commercial properties do not readily sell in the open market. Assets that sell readily are referred to as liquid and therefore inability to do so constitutes the liquidity risk. This follows the inability of the banks to fund increases in assets and meet obligations as they arise without suffering unacceptable losses (BCBS 2008). The institution is therefore unable to pay its debts due to a lack of sufficient cash to do so. The banks’ basic practice of transforming short-term deposits into long-term loans exposes the institution to high liquidity risks. Solvency risk on the other hand is more serious than liquidity risk in that the company is not capable to pay its debt given the fact that its liabilities exceed assets and therefore cannot secure a loan from anybody. This, therefore, implies that the company is on the verge of being insolvent. The aforementioned risks are almost similar but display a little different in that the former may provide an opportunity for the company to borrow finances aimed at settling its expenses, unlike the solvency risk. A company should therefore critically analyze its balance sheets to minimize future occurrence of such risk which is detrimental to the survival of the business (BCBS 2009).
Both liquidity and solvency risks are affected by the credit risk in one way or another. Credit risk involves circumstances where an investor suffers losses as a result of failure by the borrower to settle his debt as promised. This kind of risk may lead to losses including reduced cash flow, lost interests, and principle as well as elevated collection costs. At the outset, the business or consumer may fail to pay for his debt such as trade invoice or employee’s earned wages when due resulting in a suppressed cash flow hence the investors will be deprived of sufficient cash to meet their expenses thereby contributing to liquidity risk. Banks that make long-term loans and at the same time receive short-term deposits are exposed to liquidity risks since they may not be able to meet their obligations as well as finance increased assets without incurring unnecessary losses (Bank Supervision Department 2008). Alternatively, failures by a consumer or business to settle their debts such as mortgage loans, credit cards, or other loans as well as bankruptcy protection of certain insolvent borrowers by the government may subject the investor to substantial losses. Consequently, the investor may be incapable of settling his debts given the increased liability compared to the assets. Furthermore, he is not in a position to secure a loan, therefore, risks being insolvent.
Dynamic provisioning entails economic policy adopted by the banking regulators to amplify financial or economic fluctuations in an attempt to manage the financial risks they are facing. Dynamic provisioning through its anticyclical nature boosts the resilience of both individual banks as well as the banking system in general. According to Saurina (2008), dynamic provisions entail assessment for impairment in a collective manner. This is a means of covering losses that have not been identified on specified loans followed by delivery of reliable information to the investors on issues concerning the risk status of the business as well as its financial position (Saurina 2008). Banks are exposed to risks due to their investment and lending practices and are therefore entitled to hold a certain amount of capital reserves that are commensurate to the risks. Generally, a bank needs to hold more capital when exposed to greater risk to ensure its economic stability as well as guarantee its survival in the financial market. The enactment of such international standards is meant to protect the international financial system against the financial risk should a series of international banks or a major bank collapse (Saurina 2008). According to business theory and finance, procyclicality entails the positive correlation between any economic aspect with state of the economy. Such economic quantities as exemplified in the stock prices usually increase as a result of economic growth. Generally, because of Procyclicality, the economic quantity is directly proportional to the economic and financial fluctuations where an increase in the former results in an increase in the economic quantity. Dynamic provisioning, therefore, ensures that the risks of loan losses are catered for at an appropriate time (World Bank Group 2009).
The aforementioned rigorous risk and capital management recommendations by financial regulators are very vital in safeguarding the financial health of the banking industry. To begin with, the stipulated rules require banks to elevate their capital ratios in circumstances where they face greater risks. This implies that there will be a reserved amount of finance which would be helpful for the bank in meeting its long-term fixed expenses thereby realizing long-term growth. Moreover, it may also provide for reduced lending in an attempt to minimize default risks as a result of the inability of borrowers to pay their debts. Such rules, therefore, ensure that the banks operate on assets that exceed liabilities thereby avoiding solvency risks. According to the World Bank Group (2009) banks can enact buffers in good times that would be useful to them in bad times through detecting and covering credit losses mainly in the loan sector in the early stages.
Problems associated with liquidity have adverse impacts on the financial health of any business venture and should therefore be handled with utmost care to ensure the survival as well as economic stability of the investment. Proper management of liquid financial resources is fundamental to the financial wellbeing of every licensee in respect to meeting the liabilities as they become due, as well as liabilities that do so earlier than expected (BCBS 2008). Sound management programs, however, depend on the nature, size, and complexity of the risk in the business and therefore adoption of such practices should be undertaken in full regard to the complexity and type of the business operations (Airgedais 2009). Liquidity risk can be internally controlled through a variety of measures including adoption of policies and procedures for controlling the risk, identification and evaluation of risks, Management Information Systems that adequately monitor the risks as well as ensuring compliance with established policies and procedures through independent reviews (BCBS 2008).
To begin with, every bank is entitled to enact and implement a documented policy and procedure on both domestic and foreign currency liquidity for the complexity and nature of their investment. The bank’s goal of safeguarding financial strength in all situations should be addressed by the document (BCBS 2008). The policy should also guide the bank on ways of accessing a variety of financial sources from the market in order to manage its liquidity. The bank’s management team should be informed of other risks and how they impact liquidity risk. Moreover, the business departments involved in activities that may affect liquidity should also be aware of the management policy framework. The management policy should also provide for assessment of the deposit structure taking into account the trend and amount of various deposits offered by the bank, interest rates and the existing market interest rate, deposits of non-residents as well as public funds among other components (BCBS 2009). In cases where the business is experiencing unavoidable loss of funding, the management policy provides for systematic procedures that ensure restoration of the liquidity position of the business. Additionally, the policy should ensure that the liquidity risk management processes are adhered to by establishing approval processes. More importantly, the policy should ensure sound liquidity management through the establishment of liquidity ratio standards such as limits for the financing of long-term assets with short-term liabilities. Finally, in the event of breaches of internal control, the policy should provide guidance through well-established procedures (Taylor 2008).
Secondly, internal control of liquidity risk entails the identification and further evaluation of such risks. It is noteworthy that liquidity risk usually arises from other inherent risks including credit risk, operational risk, the market risk among other risks, and therefore its management requires the bank’s understanding of these risks and the ways in which they affect the liquidity risk. A bank may be prevented from acquiring finances at fair prices due to the bank’s problems about the aforementioned inherent risks thereby increasing its liquidity risk. The bank should therefore consider its current business activities and understand how they may affect the future profile of liquidity risk. For instance, liquidity risk may result from inflows realized when expected assets surpass actual assets upon sales due to credit risk. Contingent liability may give rise to liquidity demands in cases where it experiences unpredictable cash flow thereby causing liquidity risk (Bank Supervision Department 2008). The banks should therefore establish the impact of such liability by embarking on scenario analysis to minimize liquidity risk. Besides, the disruption of funding structure by the changes of market conditions as well as funding sources may also cause liquidity risk to the bank.
Additionally, credit institutions should thereafter adopt and uphold consistent liquidity risk measurement methods including calculation on a daily basis of its liquidity position to enhance efficient and effective management and monitoring of its overall financial requirements in an attempt to control liquidity risk (BCBS 2009).
The banks should also implement and maintain suitable management information systems (MIS) that aid in the monitoring of liquidity risk. Such information system should be adequate in monitoring, measuring, monitoring, controlling as well as reporting liquidity risk bearing in mind the size, nature, and complexity of the credit institution. The MIS should provide a liquidity report that merges with the financial data produced by the licensee. Moreover, it should point out infringements of parameters or approaches to such limits by the licensee as well as ensure that the licensee’s procedures and policies are complied with. The system should as well provide the management team with adequate information at an appropriate time concerning the licensee’s liquidity position. The system’s flexibility demonstrated by its ability to handle any rising contingency is highly recommended. Lastly, the policy should entail contingency funding plans usually generated by the management and approved by the institution’s Board of Directors (BCBS 2008).
Finally, banks need to establish an internal but independent audit team that would use an independent review process to ensure that the enacted policies and procedures are adhered to and that the set objectives are achieved. The team would also evaluate the process of liquidity management in an attempt to identify lapses as well as ensure timely corrective measures are taken (BCBS 2008).
Financial regulators on the other hand may control liquidity risk through a variety of measures including the enactment of legislations that guide the banks and other financial institutions in their lending and borrowing activities. Such legal provisions like the Irish Financial Services Regulatory Authority bestow upon the financial regulator the power to license and supervise banks and other credit institutions (Airgeadais 2009). This act compels the institutions to provide both qualitative as well as quantitative liquidity requirements for their institutions thereby ensuring that they establish sound and sensible liquidity management policies and procedures. Moreover, the financial regulators also ensure that the banks implement adequate internal systems that are aimed at monitoring and addressing mismatches between liabilities and assets.
The financial regulators may also monitor the materiality test to cash flows so far adopted by the credit institutions. Credit institutions will be allowed to exclude small cash inflows and outflows in circumstances where the gap ratio within a time band is zero as long as such actions are documented and are coincidental to the previous gap ratio of the time band. The financial regulator is entitled to monitor materiality concession which is consistently applied by the credit institutions on inflows and outflows and adjust them with respect to the development of the financial industry (Airgeadais 2009).
Finally, the financial regulatory authority has to ensure that the bank’s open deposit protection accounts with both the central bank and the regulatory body where they are required to deposit and maintain a specified amount of money that is not available for the banks’ liquidity purposes (Airgeadais 2009).
Banks encounter a variety of problems as far as control of liquidity is concerned. At the outset, they face difficulties in identifying and assessing levels of risks from a variety of sources in the financial market. Additionally, vices such as internal fraud within the banks greatly hinder the liquidity control process. This may encompass bribery, evasion of tax, misappropriation of an institution’s assets among other corrupt practices. External fraud including forgery, theft of information as well as damages as a result of hacking also affects the effective control of liquidity by the banks. Moreover, systems failures such as hardware failure as well as business disruptions are barriers to such effective control. Damages to banks’ assets either by natural disasters or other means such as vandalism thwart the bank’s efforts as well. Finally delivery, execution, as well as Process Management within the bank’s management hierarchy have proven to hamper the banks’ ability to effectively and efficiently control liquidity. Such practices may include errors associated with accounting as well as data entry and loss of client’s property due to negligence.
The financial wellbeing of any institution is greatly reliant on the sound management of its financial resources. Liquidity management for instance is fundamental for proper functioning of credit institutions. Such management practices depend upon the nature, size, and complexity of the business operations and have to be applied in regard to the aforementioned variables. The institution’s financial wellbeing is also affected by the existing rules and regulations that guide their financial practices of lending and investment. Generally, any business enterprise is initiated to make profits and therefore the uncertainties that lower the actual returns below expected returns needs to be eliminated in order to achieve the stated objective. The financial risks are detrimental to credit institutions and should therefore be managed in a proper manner to ensure survival as well as economic stability of the institutions.
Airgedais, R., 2009. Requirements for the Management of Liquidity Risk. Dublin: Irish Financial Services Regulatory Authority. Web.
Bank Supervision Department, 2008. Liquidity risk management guideline. Barbados: Central Bank of Barbados. Web.
Basel Committee on Banking Supervision (BCBS), 2008. Principles for sound liquidity risk management and supervision. Basel: Bank for International Settlements. Web.
Basel Committee on Banking Supervision (BCBS), 2009. Strengthening the resilience of the banking sector. Basel: Bank for International Settlements. Web.
Saurina, J., 2009. Made in Spain and working well. London: Financial World. Web.
Taylor, M., 2008. Revisiting Basel. London: Financial World. Web.
World Bank Group, 2009. Crisis response; public policy for the private sector. Virginia: Grammarians, Inc.