Liquidity is the ability to meet the company 's perceived and sudden cash needs.
The need for cash arises owing to withdrawal of deposits, approach of a repayment period (maturity term) of obligations, granting means on loans, as on new, and continuation of delivery of means on old loans.
Cash demand is met by increasing deposits and loans, repaying debt to the company, investing in fixed-term securities and selling assets.
Insufficient liquidity can cause an unexpected shortfall in means of payment, which must be covered by unusual increased costs, thus causing a decrease in the profitability of the institution.
At worst, inadequate liquidity can lead to insolvency of the institution, in terms of short-term liabilities.
On the other hand, excessive liquidity can lead to low income on assets and thus adversely affect the agency 's returns.
Bank liquidity risk management in maintaining adequate liquidity, which often depends on how the market perceives the bank 's financial strength.
If its condition appears to be deteriorating, usually due to significant losses incurred in connection with loans, there is a need for extraordinary liquidity.
Depositors withdraw their deposits or do not renew them when deposits expire.
The bank begins to purchase deposits at a higher price, issues debt cash obligations, creating serious problems for overall profitability.
The bank 's ability to find sources of financing in money markets at all costs ultimately falls as potential investors cut or close their credit lines the bank enjoyed.
At the same time, banks, whose capacity to raise funds is becoming both more limited and more expensive, often experience the effect of mass disbursement of funds due to the need to cover their obligations on outstanding debts.
There are two main liquidity management methods:
- bank asset management - used mainly by small banks;
- Liability volume and structure management - used mainly by large and medium-sized banks with strong positions in monetary markets, where the level of highly liquid assets is minimized.
The liquidity risk management process sets the following liquidity limits:
- current liquidity limit as absolute amount - liquidity deficit limit (excess of liabilities over assets)
- future liquidity limit as a relative indicator: the limit liquidity deficit ratio, which is the ratio of the liquidity deficit to the bank 's assets
As a limit of current liquidity, the limit amount of liquidity deficit for the period of up to 1 month is usually set.
Maintenance of a limit is provided with calculation of volume of idle assets (the correspondent account and cash desk) which have to provide calculations for means "poste restante" and to urgent means.
The forward liquidity limit is an aggregate indicator - the limit ratio of liquidity deficit.
The bank 's asset and liability management strategy directly affects liquidity risk planning and associated limits.
The size of the limit is determined by the bank 's liquidity policy - conservative or aggressive.
In the first case, there is no current liquidity deficit and the limit is 0.
In the second case, it should be equal to the volume of possible attraction of funds in the interbank lending market and the volume of funds from the sale of highly liquid assets.
Conservatism of the bank 's policy implies that there is no gap between assets and liabilities within one fixed-term group or placement for shorter terms than those of raised liabilities.
At the same time, the limit of prospective liquidity will be close to 0.
Aggressive policy implies an increase in the limit of prospective liquidity, that is, an increase in the framework in which the terms of assets can exceed the terms of liabilities.
According to experts, the upper limit of deviations should be such that by the time of reaching the urgent group "up to 1 month," the gap is within the limits of the current liquidity.
There are the following ways to assess and manage liquidity risk:
- Analysis and evaluation of the ratio of assets to liabilities by liquidity, i.e. assets and liabilities are allocated to the respective groups according to the degree of liquidity decline and their duration and quality.
- break method or time ladder is based on the comparison of active and passive balance sheet items, taking into account the time remaining before their repayment. The gaps revealed by the comparison show in which time interval the bank will experience a shortage or excess of liquidity.