IIMFC2022016-V005000
Summary
TLDRThis video script delves into liquidity risk management strategies for financial institutions. It highlights the importance of maintaining liquidity to prevent crises and protect reputations. The script outlines two main approaches: the fundamental approach, which involves investing in highly liquid assets and complying with regulatory measures, and the technical approach, encompassing the working funds and cash flow methods to forecast and manage cash inflows and outflows. The maturity ladder model and asset securitization are also discussed as tools to mitigate liquidity risk, providing a comprehensive overview of the topic.
Takeaways
- 💡 Liquidity risk management is crucial for financial institutions to handle the ability to generate fresh liabilities in response to changes in assets or liabilities.
- 🏦 Banks aim to eliminate liquidity risk due to its potential serious impact on their reputation during a crisis.
- 💼 Financial institutions are required to invest in highly liquid assets like short-term government bonds to mitigate liquidity risk, which may reduce interest income and profits.
- 🔍 The fundamental approach to managing liquidity risk involves investing in easily convertible assets and complying with regulatory measures like maintaining cash reserves.
- 📊 On the liability side, banks should focus on sourcing funds that are likely to remain with the institution for an extended period, avoiding funds that can be withdrawn quickly.
- 📈 Banks must analyze cash inflows and outflows to source funds ahead of need, considering the mix of retail and corporate banks in the financial system.
- 📉 The technical approach to liquidity risk focuses on short-term liquidity, using methods like the working funds approach and the cash flow approach.
- 💰 The working funds approach categorizes funds into volatile, vulnerable, and stable, helping banks estimate expected cash outflows and manage liquidity proactively.
- 📋 The cash flow approach, or maturity ladder model, involves forecasting cash inflows and outflows over different planning horizons to determine liquidity needs, especially in the short term.
- 🔑 Asset securitization is another method used to manage liquidity risk, where future cash flows are repackaged into negotiable securities and sold to investors for immediate liquidity.
- 🌐 The maturity ladder model is a widely accepted approach for liquidity risk management, mandated by several central banks for institutions under their oversight.
Q & A
What is liquidity risk management in the context of financial institutions?
-Liquidity risk management refers to the potential ability of a financial institution to generate fresh liabilities to cope with a decline in liabilities or an increase in assets. It involves managing the conflicting objectives of maintaining sufficient liquidity to meet obligations while also managing the risk of a liquidity crisis that could affect the institution's reputation and profitability.
Why is it important for banks to eliminate liquidity risk?
-A liquidity crisis in a bank can have serious ramifications in terms of its reputation and financial stability. Well-run banks aim to eliminate liquidity risk to ensure they can meet their short-term obligations and maintain trust among their customers and stakeholders.
What are some of the assets that financial institutions invest in to manage liquidity risk?
-Financial institutions invest in highly liquid assets that are short-term in nature or risk-free instruments such as government bonds. These assets can be easily turned into cash and typically offer lower returns, which may reduce the institution's interest income.
What is the fundamental approach to managing liquidity risk?
-The fundamental approach to managing liquidity risk involves investing in assets that can be easily converted to cash, such as Treasury bills and government securities, and complying with regulatory measures like maintaining cash reserves or statutory liquidity reserves.
How should banks focus on the liability side of the balance sheet to manage liquidity risk?
-Banks should focus on sourcing funds that are likely to remain with the bank for an extended period rather than funds that could be withdrawn at short notice. They should also carefully analyze their cash inflows and outflows to source funds ahead of need.
What are the two main approaches to managing liquidity risk mentioned in the script?
-The two main approaches to managing liquidity risk mentioned are the fundamental approach and the technical approach. The technical approach further includes the working funds approach and the cash flow approach.
Can you explain the working funds approach to managing liquidity risk?
-The working funds approach involves segregating the source of funds that are coming up for maturity in the near term into three categories: volatile funds, vulnerable funds, and stable funds. Banks then estimate the likelihood of withdrawal for each category and source liquidity to meet the expected cash outflow.
What is the cash flow approach to managing liquidity risk, and how is it used?
-The cash flow approach, also known as the maturity ladder model, involves laying down planning horizons and estimating both cash inflows and outflows for each horizon. Banks forecast these for short-term periods and determine liquidity needs with a focus on maintaining sufficient liquidity to cover any shortfalls.
How does the maturity ladder model help financial institutions manage liquidity risk?
-The maturity ladder model helps by providing a forecast of cash inflows and outflows over different planning horizons. This allows institutions to identify potential liquidity gaps and take proactive measures to ensure they have sufficient funds to cover their obligations.
What is asset securitization, and how can it be used to manage liquidity risk?
-Asset securitization is a method where financial institutions package future cash flows, such as repayments of long-term loans, into negotiable securities that are then issued to investors. This allows the institution to realize those future cash flows immediately on a discounted basis, thereby managing liquidity risk.
How does the script illustrate the use of a spreadsheet in managing liquidity risk?
-The script uses a spreadsheet example to demonstrate how a bank can forecast cash inflows and outflows over different planning horizons, calculate net cash flows, and understand its liquidity position at various points in time. This helps the bank to identify potential liquidity issues and manage them proactively.
Outlines
🏦 Liquidity Risk Management Basics
This paragraph discusses the concept of liquidity risk management in financial institutions, emphasizing the need to balance the potential for generating new liabilities with the management of existing assets and liabilities. It highlights the importance of maintaining a good reputation by avoiding liquidity crises and the strategies employed to mitigate such risks, including investing in highly liquid assets like government bonds and maintaining cash reserves. The paragraph also introduces two fundamental approaches to liquidity risk management: the fundamental approach, which focuses on easily convertible assets and stable funding sources, and the technical approach, which deals with short-term liquidity planning.
📊 Techniques for Liquidity Risk Management
The second paragraph delves into the technical approach of liquidity risk management, describing two specific methods: the working funds approach and the cash flow approach. The working funds approach involves categorizing liabilities into volatile, vulnerable, and stable funds based on their likelihood of withdrawal at maturity. The cash flow approach, also known as the maturity ladder model, requires banks to forecast cash inflows and outflows over various planning horizons and to ensure they have sufficient liquidity to cover short-term needs. The paragraph provides a detailed example of a spreadsheet that outlines cash inflow and outflow items, demonstrating how banks can use this model to anticipate and manage their liquidity positions over time.
💼 Advanced Liquidity Risk Management Strategies
The final paragraph introduces advanced strategies for liquidity risk management, such as asset securitization, where future cash flows from long-term loans are repackaged into negotiable securities and sold to investors to realize immediate funds. The paragraph also discusses the importance of managing short-term liquidity carefully, using the examples of negative and positive cash flow scenarios over different planning horizons. It emphasizes the need for banks to anticipate and plan for fluctuations in liquidity to ensure they remain financially stable in both the short and long term.
Mindmap
Keywords
💡Liquidity Risk Management
💡Financial Institution
💡Highly Liquid Assets
💡Interest Income
💡Fundamental Approach
💡Regulatory Measures
💡Working Funds Approach
💡Cash Flow Approach
💡Asset Securitization
💡Maturity Ladder Model
💡Net Cash Flow
Highlights
Liquidity risk management is crucial for financial institutions to handle potential declines in liabilities or increases in assets.
A liquidity crisis in a bank can severely impact its reputation, making it essential for banks to manage liquidity risk effectively.
Financial institutions are required to invest in highly liquid assets like short-term government bonds to mitigate liquidity risks.
Managing liquidity risk can lead to a reduction in interest income and potentially affect the bank's overall profits.
The fundamental approach to liquidity risk management involves investing in easily convertible assets and complying with regulatory measures.
Focusing on the source of funds, such as those likely to remain with the bank for an extended period, is key in managing liquidity risk.
Banks should analyze cash inflows and outflows to source funds ahead of need, considering the mix of retail and wholesale banks.
The technical approach to liquidity risk management focuses on short-term liquidity through the working funds and cash flow approaches.
The working funds approach categorizes funds into volatile, vulnerable, and stable funds based on the likelihood of withdrawal at maturity.
Banks need to proactively source sufficient liquidity to meet expected cash outflows, as demonstrated by the working funds approach.
The cash flow approach, or maturity ladder model, is used by banks to forecast cash inflows and outflows and determine liquidity needs.
The maturity ladder model involves planning horizons and estimating cash flows to manage liquidity risk effectively.
Asset securitization is another method used by financial institutions to manage liquidity by repackaging future cash flows into negotiable securities.
Banks can realize future cash flows immediately through asset securitization by issuing negotiable securities to investors.
The maturity ladder model proposed by the Bank of International Settlements is widely used in liquidity risk management.
Banks must manage liquidity carefully, especially in the short term, to avoid cash flow problems despite long-term positive cash inflows.
Understanding the cash inflow and outflow dynamics is crucial for banks to manage liquidity risk effectively using the cash flow approach.
Transcripts
liquidity risk management refers to the
potential ability of a financial
institution to generate fresh
liabilities either to cope with any
decline in liabilities or increase in
assets implicitly therefore liquidity
risk management involves managing the
two conflicting objectives for any
financial institution one a liquidity
crisis in the bank could have serious
ramifications in terms of its reputation
hence most well-run banks do all
possible to eliminate liquidity risk
eliminate potential liquidity risks
financial institutions will be required
to invest in highly liquid assets which
are short-term in nature or in risk free
instruments such as government bonds and
both of which the eels
would be very low in other words
managing liquidity risk involves
potential reduction in interest income
and therefore an adverse impact on the
overall profits of the bank we will now
look at some techniques used by
financial institutions to manage
liquidity risk the most fundamental one
is the fundamental approach this
approach involves investing in assets
that can be turned into cash easily
example investment in Treasury bills and
government securities and/or complying
with regulatory measures such as
maintaining cash reserves statutory
liquidity reserve x' etc on the
liability side of the balance sheet the
focus should be on source of funds for
example source funds that are likely to
remain with the bank for an extended
period of time rather than funds that
could be withdrawn at short notice
furthermore banks should carefully
analyze its cash inflows and cash
outflows and based on that gap source
funds ahead of need to remember
financial systems in most countries
would have a judicious mix of retail
banks that are implicitly deposit rich
hence liability led visibly wholesale
banks or corporate banks that are asset
led and always hungry for funds the
second approach to manage liquidity risk
is the technical approach the technical
approach essentially focuses on
liquidity in the short term this is
achieved through two methods the first
one is called the working funds approach
and the second is called the cash flow
approach let's look at both of these
approaches in some detail first working
funds approach this involves segregating
the source of funds that means the
liabilities that are coming up for
maturity in the near term into three
categories volatile funds vulnerable
funds stable funds wallet I funds
includes funds that are sure to be
withdrawn when they come up for maturity
for example based on past data
the bank has determined that out of a
deposit base of 10 million currency
units 3 million currency units of
certificate of deposits and fixed
deposits will be withdrawn when they
mature that leaves seven million CCU out
of the 10 million
CCU vulnerable funds includes funds that
are likely to be withdrawn on maturity
any above example let's say four million
CCU of the remaining seven million CCU
are vulnerable assuming based on past
era fifty percent probability or
the drawl the cash outflow for the bank
would be a further two million CCU that
means 50% of the four million CCU of
vulnerable funds stable funds represent
those funds with the least probability
of withdrawal when they come up for
maturity in the example that we saw the
three million CCU of the 10 million CCU
that is remaining can be classified as
stable funds and therefore most likely
to be rolled over when they mature based
on the above arithmetic the banks
effective cash outflow will be 5 million
CCU in the immediate future comprising
of 3 million of volatile funds which are
sure to go away and 2 million CCU which
is 50% of the 4 million
vulnerable funds good liquidity risk
management by the bank requires that
they proactively source sufficient
liquidity to meet the expected cash
outflow of 5 million in the near term
now let's look at the cash flow approach
to manage liquidity risk this is also
referred to as the maturity ladder model
proposed by the Bank of International
Settlements in fact several central
banks around the world have mandated
this approach for liquidity risk
management to all the institutions that
they have an oversight responsibility
this approach involves laying down the
planning horizon or the buckets as they
are normally referred to an estimating
the cash inflows such as laundry
payments inflow of fresh deposits etc as
well as cash outflows by way of loan
disbursement closure of deposits etc in
each of those planning horizon or
buckets a bank forecasts these cash
inflows and cash outflows for each of
these buckets and determines the
liquidity needs for each planning
horizon with specific focus
on the short-term let's look at a
spreadsheet example to understand this
better what we have here is for planning
horizons one day one week one month six
months along the y-axis we have various
items of cash inflow such as maturing
assets that is loans and bonds that are
maturing in that coming planning horizon
assets that are available they are not
maturing but they are available for sale
if required therefore they could be used
for liquidity management then the
potential for additional deposits open
borrowing limits with other institutions
and portfolio that is ready to be
securitized there could be other lines
of cash inflow but in the example I have
taken only these if you look at the cash
outflows for this particular institution
maturing deposits unlikely to be renewed
which means that be a cash outflow loans
that have been committed which are
likely to be drawn down by the
borrower's fresh investments in bonds
and securities that the institution
would like to make and setting aside
some cash for unforeseen events so these
are the cash outflow items that we have
considered there could be other items of
cash outflow just like there could be
other items of cash inflow now if you
look at for example the planning horizon
for the next 24 hours what it shows you
is the CCU in millions that are likely
to inflow against each of these line
items and the total adds up to a hundred
and sixty three million CCU and the cash
outflows indicate against each of those
line items what is the cash outflow for
example 47 million CCU or maturing
deposits that are unlikely to be renewed
and therefore the cash will go out of
the bank's system and so on and so forth
now this adds up to a hundred and fifty
five the net cash flow is positive which
means one hundred and sixty three cash
in
- 155 cash outflow which gives you a
total of 8 million CCU so in other words
as of close of business tomorrow or the
next working day this institution is
likely to be in the money by 8 million
CCU if you look at the next time horizon
which is one week ahead you have total
cash inflows of 107 total cash outflows
of 120 so the institution is out of the
money by 13 million that's why the
negative sign which is arrived at as the
difference between 120 which is the cash
outflow and 107 which is a cash inflow
now on a cumulative basis - 13 plus
states gives you a figure of -5 now what
this denotes is ceteris paribus
everything remaining constant this
institution would expect that one week
from now it would be out of the money by
5 million CCU and if you take this
forward to one month the cash inflows
are 76 the cash outflows are 99 the
institution is out of the money by 23
that's why the - 23 cumulatively
therefore minus 5 which is carried over
from the previous planning horizon up to
one month turns out to be minus 28 now
this is not a very happy situation for
the bank but it can still cope with it
because in the long term its cash
inflows amount to 131 whereas its cash
outflows amounts to only 79 so if we
were to look at a six-month time horizon
this institution is in a pretty happy
state because it is 24 million CCU's in
the money so what it needs to manage
very carefully in terms of which
liquidity is this minus 5 and this minus
28 it does not have a liquidity problem
on an overnight basis it does not have a
problem if you look at a planning
horizon that is 6 months ahead hope that
spreadsheet example helped you
understand how the
maturity led a model proposed by the
Bank of International Settlements is
used by financial institutions to manage
liquidity risk asset securitization is
another method used by several financial
institutions to manage liquidity this
involves taking future cash flows such
as repayment of long-term loans mortgage
loans etc and repackaging these cash
flows into negotiable securities issuing
them to investors and realizing those
future cash flows immediately on a
discounted basis we will discuss asset
securitization in much greater detail in
a later session in this course
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