How the Liquidity Risk manifests in Banks?

Liquidity risk arises when a bank fails to meet its contractual obligation in its daily operations due to non-receipt of adequate inflow of funds. If you call a bank is having adequate liquidity, it means that bank is in a position to efficiently discharge its financial obligations both at expected and unexpected short term financial demand. Here we examine how the ‘Liquidity risk’ manifests in banks.

Funding Liquidity risk: The term ‘Funding Liquidity risk’ is used when a bank will not be able to fund the increase in assets to be able to meet the expected and unexpected financial obligations efficiently as they come due. It normally arises due to unanticipated withdrawal or non-renewal of large value term deposits by the customers. This type of risk exposes the bank when it does not have contingency plan to meet short term financial demands.

Time risk: The inability of the bank to convert its assets or securities to cash at an appropriate time due to non-receipt of expected inflow of funds. This type of risk occurs when the loan accounts becoming Non-Performing Assets (NPAs) due to non- payment of loan installments and interest by the borrowers as per loan agreement. The time risk causes substantial changes in income and economic value of banks due to loss of profit and capital.

Call risk:  Another type of liquidity risk is called ‘Call Risk’. This type of risk arises due to ‘Crystallization’ of contingent liability. In this case, while discharging obligation towards contingent liabilities, banks are forced to divert their funds reserved for other profitable investments,

Market Liquidity risk: Market Liquidity risk arises due to inadequate market depth or because of market disruption. In such a situation the bank cannot easily counterbalance or eliminate a position at the usual market price. Such situation affects banks financial situation or its daily operations.

Strategies for mitigation of liquidity risks:

For the purpose of mitigating liquidity risks, banks set up Asset –Liability Management Committee (ALCO) within Risk Management Department. The main function of this committee is to prepare advance assessment with regard to need of funds and coordinating with various sources of funds available to the bank under normal and stressed condition. Basel III accord prescribes two minimum standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for funding liquidity for achieving the two separate but complementary purposes. The LCR promotes short-term flexibility in the event of liquidity troubles. It enables banks to maintain adequate levels of unencumbered high quality liquid assets (HQLAs) to survive an acute stress scenario lasting for 30 days. In the other hand, the NSFR limits overreliance on short-term wholesale funding and encourages reduction of funding risk over long term time horizon with sufficient liquidity on an ongoing basis. The NSFR generally calibrate that longer-term liabilities are assumed to be more stable than short-term liabilities and short term (maturing in less than one year) deposits provided by retail customers and funding provided by small business customers are behaviorally more stable than wholesale funding of the same maturity from other counterparties. In this backdrop, RBI permitted banks to have the discretion to offer differential interest rates based on whether the term deposits are with or without-premature-withdrawal-facility. This rule has an exception that term deposits of individuals (held singly or jointly) of ₹ 15 lakh and below should, necessarily, have premature withdrawal facility. Reserve Bank has already started phasing in implementation of the Liquidity Coverage Ratio (LCR) from January 2015 and is committed to the scheduled implementation of Net Stable Funding Ratios (NSFR) from January 1, 2018 for banks in India.

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