Sources of Liquidity Risk

Maturity transformation

Banks usually act is financial intermediaries that transform the maturity of assets in order to make earnings and hence profits. To achieve this, they receive customers’ deposits as liabilities and lend loan as assets. A problem occurs when the banks use short term liabilities which are referred to as liquid assets to fund long term loans which may be seen as illiquid (Wendy & Mayer, 2003, p. 110).

There are different levels of liquidity and the most liquid asset that form can hold is cash. The liquidity increases from cash, to short term instruments such as the trade receivables, to the short term debt instruments such as promissory notes and so on (Jayaratne & Philip, 1996, p. 136). The actual source of a liquidity risk emanates from the bank’s inability to convert the illiquid assets to cash without incurring losses at the time when the need arises (Eitemann & Stonehill, 1998, p. 256). It can also arise from unexpected withdrawals or calls from customers who hold deposits that have been used to fund long term loans.

Macro-economic imbalances

Liquidity risk can also be caused by the macro economic factors that are exogenous to the financial institution. These factors include the financial markets under stress such that the markets behave abnormally and other macro-economic imbalances (Eldred, 1989, p. 213). When a bank operates in a financial market under stress, the liquidity position of the bank may be adversely affected because the capital markets may fail to avail funds to the bank if it intends to raise them through the capital markets.

When such a bank is unable to raise funds through the markets, the depositors receive red flag signs from the bank and in a move to protect their money; many of them move their deposits to other banks. This in turn causes a serious problem in the bank’s liquidity and more often than not, the bank is unable to fund its short term cash requirements as they fall due (Kamara, 1994, p. 119).

Other cases of liquidity risk arise when a financial institution loses it credit rating and as a result the finance credit rating falls (Madura, 1999, p. 153). The firm is then unable to realise the full expected cash inflows from the market trading and as such loses a significant amount of money. It is a times hard to separate between solvency and liquidity. A firm that fails its liquidity test most likely becomes insolvent and an insolvent bank can become illiquid (Taylor, 1996, p. 211). These two terms are used hand in hand and they almost refer to the same concept.

Measurement of liquidity risk

There are various models available in for measuring the liquidity of a bank. This paper will present the ‘asset classification model’ that looks at the ‘cat’ and ‘mat’ (Van Lelyveld & Knot, 2008, p. 96). These are terms used to describe the category of the assets as well as the maturity of the asset. Since the most common bank assets are the loans, this model will concentrate on loans as the bank’s asset (Vance, 2003, p. 253).

Category ‘cat’

The asset category has to do with the measurement of the liquidity creation ability by a bank. A good example of an illiquid asset is a business loan. For these assets to be sold easily when a need for liquidity arises, the bank must incur huge costs (Matz & Neu, 2007, p. 123).

Maturity ‘mat’

Maturity deals with the life span of some assets. Some assets mature in short term while other mature in the long term. As such, the assets that mature in the short term are referred to as self liquidating since they are able to avail cash soon (Matz & Neu, 2007, p. 136). For the purposes of the ‘mat’ model, the short term assets are referred to as liquid while the long term ones are referred to as semi-liquid.

The second step in measuring the liquidity risk of these assets is assigning of weights on these assets. The assigning of the weights depends on the intuition that banks act as intermediaries for liquidity creation for the money lenders. Positive weights are allocated to various assets with the liquid assets earning higher points than the illiquid ones.

The final step in measuring the liquidity of the assets is combining the ‘mat’ and the ‘cat’ measures. The values obtained are then classified into different measures; ‘cat’ versus ‘mat’ for the loans, and further use the ‘cat fat’ and the ‘cat non-fat’, and the ‘mat fat’ and ‘mat non-fat’ for the balance sheet activities of the loan assets and liabilities (Matz & Neu, 2007, p. 138).

Once these values are obtained, the relationship between the assets and the liabilities of the banks is obtained and this is used to establish the liquidity risk position of the bank. The banks that have more long term assets funding short term liabilities are usually exposed to the liquidity risk since a default in the assets are referred to as illiquid yet they fund liquid short term liabilities which are liquid in nature (Walter & Smith, 1999, p. 196).

Managing Liquidity risk

The Basel Committee has been in a constant and continual struggle to underpin and manage the liquidity adequacy performance by the commercial banks. This was followed by a series of supervisory guidelines by the committee that were aimed at ensuring that the banks are adequately cushioned from the liquidity risk and subsequent insolvency.

The Basel committee on banking supervision designed a three pillar architect that should provide the guidelines on the regulation of the banks. The liquidity risk management is found in the first pillar that deals with the capital requirements for credit risk, market risk and the operational risk (Matz & Neu, 2007, p. 156). The liquidity risk is a subset of credit risk and as such, the measures applicable in managing the credit risk are simulated to manage the liquidity risk.

The most practical way that the regulatory bodies and regulate the management of risks among the banks is to impose a capital requirements for a given type of risk exposure. The banks’ management are required to have a reserve capital with the central bank to provide a cushion on the potential liquidity problem in the case of asset illiquidity. This reserve capital is required to be kept in cash (Tattersall, 2006, p. 201).

According to the Basel committee on banks regulation, the banks in addition to reserve capital are required to carry out regular stress testing exercises that are aimed at pointing at the liquidity position of the bank. A bank that has plunged into liquidity problems is more likely to become insolvent and as such, the stress test is aimed at indicating the nearness to liquidity and the bank is able to take corrective measures in order to boost the liquidity position of the institution.

Conclusion

In conclusion, as it has been discussed there are several sources of liquidity risk for banks. While the management of the bank is responsible for managing the internal sources of liquidity such as the maturity transformation, the exogenous sources such as the macro-economic imbalances present challenges that the management of the bank is not in control of. It is therefore a collective responsibility of both the banks and the various financial sector regulatory authorities to ensure that the management of liquidity risk is dealt with at both the micro and the macro levels.

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