IIMFC2022016-V005000

Summary

This 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on sourcing funds that are likely to remain with the institution for an extended period, avoiding funds that can be withdrawn quickly.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

00:00

🏦 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.

05:01

📊 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.

10:01

💼 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.

Keywords

💡Liquidity Risk Management

Liquidity risk management is the process by which financial institutions ensure they have sufficient liquid assets to meet their short-term obligations without significantly affecting their financial stability. In the video, it is the central theme, as it discusses the potential ability of a financial institution to generate fresh liabilities to cope with declines in liabilities or increases in assets. The script emphasizes the importance of managing liquidity risk to avoid serious ramifications such as damage to the institution's reputation.

💡Financial Institution

A financial institution refers to an organization that manages financial transactions, such as banks, credit unions, and investment companies. In the context of the video, financial institutions are the primary actors in liquidity risk management, needing to balance the conflicting objectives of maintaining sufficient liquidity to prevent a crisis and maximizing profits by investing in assets that may not be as liquid.

💡Highly Liquid Assets

Highly liquid assets are financial instruments that can be quickly converted to cash with minimal impact on their price. The script mentions that financial institutions manage liquidity risk by investing in such assets, like short-term Treasury bills and government securities, which are considered safe and easily convertible to cash, albeit with potentially lower returns.

💡Interest Income

Interest income is the money earned by financial institutions from investing in interest-bearing assets. The video points out that managing liquidity risk may involve a trade-off, as investing in highly liquid assets could result in a reduction of interest income, thus impacting the overall profitability of the institution.

💡Fundamental Approach

The fundamental approach to liquidity risk management, as described in the script, involves investing in assets that can be easily converted to cash and complying with regulatory measures. This approach is essential for financial institutions to ensure they have immediate access to funds in times of need, such as maintaining cash reserves or investing in Treasury bills.

💡Regulatory Measures

Regulatory measures are rules and guidelines set by financial authorities to ensure the stability and proper functioning of financial markets. In the context of liquidity risk management, the script refers to maintaining cash reserves and statutory liquidity reserves as examples of regulatory measures that financial institutions must comply with to mitigate liquidity risk.

💡Working Funds Approach

The working funds approach is a technique used to manage liquidity risk by classifying liabilities based on their likelihood of withdrawal at maturity. The script explains that funds are categorized as volatile, vulnerable, and stable, allowing banks to estimate their cash outflows more accurately and manage their liquidity needs accordingly.

💡Cash Flow Approach

The cash flow approach, also known as the maturity ladder model, is a method for managing liquidity risk by forecasting cash inflows and outflows over different planning horizons. The video script uses this approach to illustrate how banks can determine their liquidity needs and ensure they have sufficient funds to cover their obligations in both the short and long term.

💡Asset Securitization

Asset securitization is the process of pooling illiquid assets, such as mortgage loans, and converting them into tradable securities, which can then be sold to investors. The script mentions this as a method used by financial institutions to manage liquidity risk by realizing future cash flows immediately, thus improving their liquidity position.

💡Maturity Ladder Model

The maturity ladder model, proposed by the Bank of International Settlements, is a specific application of the cash flow approach. It involves laying out planning horizons and estimating cash inflows and outflows within those horizons. The script provides an example of how this model can be used to manage liquidity risk by forecasting and planning for the institution's cash needs over various time frames.

💡Net Cash Flow

Net cash flow is the difference between the total cash inflow and the total cash outflow over a specific period. In the video, the concept is used to illustrate the liquidity position of a financial institution at different planning horizons, helping to determine whether the institution is likely to have a surplus or deficit of funds and thus manage its liquidity risk effectively.

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