Liquidity risk

Liquidity risk
See also
Funding Operations Trading Book Asset swap Currency risk Variation Margin Concentration risk Ijarah Liquidity management Cross margining

The risk of liquidity - the risk of a situation in which the bank runs out of cash to make unexpected withdrawals from deposit accounts. Lack of liquid assets usually causes shortages of funds to finance operations on the retail and corporate market or to finance daily financial operations. If you can not find additional capital quickly, you may panic and run into the bank. The most important function of the lender of last resort is to protect the bank from the risk of losing liquidity. Maintaining liquidity comes from the Banking Law and is the responsibility of every bank.

Financial liquidity means the possibility of timely payment of current liabilities. This situation is ensured by easy exchange of assets for money. It should be remembered that maintaining liquidity should take precedence over profitability.

All operations that cause the flow of cash flows can trigger a bank's liquidity perturbation. The liquidity risk is directly related to other types of banking risk, e.g. with credit risk, market risk or operational risk.

Types of liquidity risk

The liquidity risk can be divided into primary and secondary risk:

• Primary liquidity risk - results from the management of assets and liabilities by the bank.
• Secondary liquidity risk - is associated with losses incurred as a result of adverse price changes and loss of capital.

Causes of liquidity hazards

The most important reasons for liquidity threats:

• Unplanned extension of capital involvement in bank's operating assets. Usually, these are delays in repayment of principal installments and interest resulting in a gap in the balance sheet. It is an active liquidity risk.
• Transformation of the term of acquired and invested capital (discrepancies in the periods for which capital was acquired and invested). The threat occurs when, in the situation of the intended mismatch of balance sheet items, no substitute refinancing can be started within specified maturities and maturities. This is a passive liquidity risk.
• The risk of contracts. This risk may occur as active when there is a potential risk of beneficiary claims for the implementation of the promised loans and guarantees (off-balance sheet operations). It may also have a passive form if there is a risk of unexpected withdrawal of deposits.

The liquidity risk includes both assets and liabilities. In the absence of liquidity, the liability-liability relationship is shaken. There is no liquidity standard for banks. Each of them should maintain liquidity adequately to the scale of risk taken. The liquidity of banks can be described thanks to the relation of liquid assets, i.e. cash and those that without significant delays may remain converted into total assets. The bank's liquidity is also analyzed by applying loans to deposits. If such a relationship increases, then the liquidity decreases.

Liquidity management rules

• Golden banking rule. There will be no liquidity risk if the maturities of maturities as well as the maturity of assets with amounts are matched. However, full compliance with this rule would limit the bank's usefulness as an intermediary and worsen profitability.
• Sludge rule. Not all deposits are made on the declared maturity date, that is, there are funds financing the assets.
• Rule of transfers. The existence of assets that, upon liquidation prior to the due date, will not have any financial consequences.
• The rule of maximum loss. In order to maintain liquidity, the bank is able to liquefy until it obtains a loss at the level of own funds.

The instrument used to manage liquidity is a statement of assets and liabilities based on the dates of remaining validity (maturity and due date). The bank may freely change this statement taking into account the assessment of flows, because the contractual storage period is usually not appropriate for assessing their stability. An important aspect while maintaining liquidity is the stability of funding sources. The household deposits belonging to stable sources of funding usually remain for a longer period in banks' liabilities than contractual periods. Investments from the interbank market are usually kept short and for larger amounts. It is important to build a stable deposit base.

Banks' strategies for maintaining liquidity

• Liquidity storage strategy - it consists in maintaining adequate reserves in the assets of the balance in the form of cash and easily transferable assets to cover the demand for liquidity.
• The liquidity management strategy is based on taking loans to cover immediately demandable liquidity demand. In this way, the bank reduces the costs of storing liquidity in assets, which makes the method cheaper than the previous one. However, in the case of unexpected liquidity requirements, its external coverage can be very costly and risky.
• Sustainable liquidity management strategy - it combines the two above mentioned strategies, part of the funds is stored, and the second part is borrowed, based on previously concluded contracts.

References

• Pástor, Ľ., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns. Journal of Political economy, 111(3), 642-685.
• Acharya, V. V., & Pedersen, L. H. (2005). Asset pricing with liquidity risk. Journal of financial Economics, 77(2), 375-410.
• Diamond, D. W. (1991). Debt maturity structure and liquidity risk. The Quarterly Journal of Economics, 106(3), 709-737.