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.

Examples of Liquidity risk

• Market liquidity risk: This is the risk of having to sell an asset quickly at a lower price than expected due to a lack of buyers. This is a risk especially when trading in illiquid markets such as bonds, derivatives and other complex financial instruments.
• Funding liquidity risk: This is the risk of not being able to fund a bank’s operations due to a lack of liquidity in the banking system. A bank may find itself unable to meet its financial obligations due to a shortage of cash or because other banks are unwilling to lend it money.
• Operational liquidity risk: This is the risk of not having enough cash to meet operational expenses. This can be caused by a mismatch between cash inflows and cash outflows or by the bank not having enough cash reserves to cover unexpected expenses. This kind of risk can be managed by ensuring there are sufficient cash reserves or by managing cash flows more effectively.
• Interest rate liquidity risk: This is the risk of not being able to access the capital markets due to a lack of liquidity in the market. This can be caused by market volatility, a lack of investors, or a lack of buyers or sellers of financial instruments. Banks can manage this risk by diversifying their sources of funding and by using derivatives to hedge against interest rate risk.

Advantages of Liquidity risk

Liquidity risk has a number of advantages. Firstly, it encourages banks to maintain a sufficient level of liquid assets in order to be able to meet any potential withdrawal of funds by customers. This helps to ensure that banks remain stable and solvent. Secondly, liquidity risk also encourages banks to diversify their investments and holdings to ensure that they are well diversified and can absorb any potential losses. Finally, liquidity risk also encourages banks to maintain prudent lending practices and to ensure that they do not lend too much money to any one customer. All of these advantages help to ensure that banks remain stable and solvent. *Maintaining liquidity encourages banks to have sufficient assets to meet customer withdrawals. *Diversifying investments helps to ensure that banks are well diversified and can absorb any potential losses. *Prudent lending practices help to ensure that banks do not lend too much money to any one customer.

Limitations of Liquidity risk

Liquidity risk can have severe implications for a bank's financial health, but there are limitations to how much a bank can mitigate this risk. The following are some of the limitations of liquidity risk:

• The first limitation is that a bank may not be able to access enough capital to cover its liquidity needs. This could mean that the bank may not be able to cover large customer withdrawals and could put the bank at risk of insolvency.
• The second limitation is that banks may not be able to access enough collateral to secure loans. This could mean that banks will not be able to obtain sufficient funds to cover liquidity needs.
• The third limitation is that the bank may not be able to understand its liquidity needs accurately. Inaccurate assessments of the bank's liquidity needs can lead to misallocation of resources, which in turn can lead to liquidity problems.
• The fourth limitation is that market conditions can change quickly. This can mean that banks may not be able to anticipate liquidity needs and may not have the resources to cover them.
• The fifth limitation is that banks may not have the ability to adjust their liquidity strategies quickly enough to respond to changing market conditions. This could lead to a liquidity crisis if the bank is unable to raise capital or secure loans in time.

Other approaches related to Liquidity risk

Liquidity risk can be managed through a number of approaches. These include:

• Developing a liquidity risk management system which includes policies and procedures for monitoring, assessing and managing liquidity risk.
• Establishing a liquidity buffer to absorb cash outflows and provide a cushion in the event of unexpected liquidity demands.
• Diversifying funding sources and maintaining adequate levels of liquid assets to meet short-term obligations.
• Establishing limits on funding and capital ratios to ensure that the bank has enough liquidity to meet its obligations.
• Monitoring market conditions and developing strategies to protect against potential liquidity shocks.

In summary, liquidity risk can be managed through a number of approaches, including developing a liquidity risk management system, establishing a liquidity buffer, diversifying funding sources, establishing limits on funding and capital ratios, and monitoring market conditions. By taking these steps, banks can better protect themselves and their customers against liquidity risk.

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.