Subtitle: A practitioner’s guide to liquidity, solvency, measurement, stress testing, and governance
Introduction
Liquidity is the ability of a bank to fund asset growth and meet obligations as they fall due without incurring unacceptable losses; solvency concerns long-term capital adequacy and balance sheet net worth. The two are related but distinct—institutions can be solvent yet illiquid if funding access suddenly dries up.
Section 1: Liquidity and solvency
- Liquidity: short-term capacity to generate or access cash and collateral at reasonable cost; reliant on market depth, funding diversity, and liquid asset buffers.
- Solvency: long-term condition where assets exceed liabilities and capital can absorb losses over time.
- Practical implication: prudential regimes treat them separately—capital frameworks address solvency; liquidity standards and buffers address run-risk and refinancing vulnerability.
Section 2: Forms of liquidity risk
- Funding liquidity risk: inability to roll, obtain, or retain funding to meet expected and unexpected cash outflows or collateral needs when due.
- Market liquidity risk: inability to monetize assets quickly at near-fair value due to thin markets, widening bid–ask spreads, or dislocations.
- Intraday liquidity risk: failure to meet time-critical payment and settlement obligations during the day, causing queues, overdrafts, or reputational impact.
Section 3: Liquidity management essentials
- Buffers: maintain High Quality Liquid Assets (HQLA) sufficient to cover stressed net cash outflows over a 30-day horizon; prioritize Level 1 assets.
- Stable funding: align asset tenors with stable liabilities and minimize structural maturity mismatches.
- Monitoring: daily LCR computation, ongoing NSFR compliance, currency-wise positions, and early-warning indicators.
Section 4: Key regulatory measures
- Liquidity Coverage Ratio (LCR): LCR = HQLA / 30-day net cash outflows ≥ 100%. Ensures survivability during acute stress with quality collateral.
- Net Stable Funding Ratio (NSFR): NSFR = Available Stable Funding / Required Stable Funding ≥ 100%. Promotes one-year structural funding resilience.
- Supervisory monitoring tools: maturity ladders, concentration metrics, unencumbered asset stock, market access indicators, and collateral positions.
Section 5: Factors contributing to liquidity risk
- Liability structure: high reliance on wholesale or concentrated counterparties; short-term funding shares and non-operational deposits.
- Asset encumbrance: extensive pledging limits monetization capacity; rising haircuts reduce usable liquidity.
- Market dynamics: systemic stress, rating actions, derivative margin calls, collateral downgrades, and drawdowns on committed facilities.
- Business model features: rapid growth, complex off-balance-sheet exposures, and cross-currency funding mismatches.
Section 6: Liquidity risk and the balance sheet
- Resilience drivers: stable retail/operational deposits, diversified term funding, and a deep pool of unencumbered Level 1 HQLA.
- Structural alignment: use NSFR and internal maturity gap limits to align funding tenor with asset liquidity; cap concentration and rollover dependence.
- Encumbrance governance: set limits by asset class and counterparty; track eligible vs ineligible collateral and haircut trajectories.
Section 7: Risk management framework
- Governance: board-approved risk appetite, clear limits, stress standards, and a contingency funding plan (CFP); defined roles across three lines of defense.
- Policies: LCR/NSFR compliance, currency-specific limits, intraday limits, funding concentration caps, collateral eligibility and haircuts policy, and escalation triggers.
- Reporting: concise dashboards for executives and the board—survival horizon, LCR/NSFR status, stress outcomes, and remediation progress.
Section 8: Identification and measurement
- Gap analysis: cumulative cash flow mismatches across time buckets under base and stress cases; track contractual and behavioral assumptions.
- LCR and NSFR: daily LCR with granular HQLA composition and runoff assumptions; ongoing NSFR with ASF/RSF factors.
- Monitoring tools: top-10 funding counterparties, top-10 deposit concentrations, market access metrics, unencumbered HQLA by level and currency, and repo capacity.
Section 9: Intraday liquidity management
- Forecasting: project opening balances, receipts, payments, and time-critical obligations; pre-position collateral for daylight credit.
- Controls: intraday limits, payment sequencing/smoothing, collateral calls playbooks, and alerts for queue buildups and overdrafts.
- Sources: central bank and FMU credit lines, same-day repos in HQLA, and liquidity-saving mechanisms in payment systems.
Section 10: Stress testing and scenarios
- Shock design: combine idiosyncratic and market-wide stresses—wholesale runoff, secured funding erosion, collateral downgrade, margin calls, facility drawdowns, and market depth evaporation.
- Calibration: include name-specific events (rating actions, negative news) and system events (macro shocks); vary severity and duration.
- Use test results: set buffer sizing, term-out funding, activate CFP triggers, adjust product pricing, and refine deposit behavior assumptions.
Section 11: Disclosures and the Indian context
- Public disclosures: LCR averages, HQLA mix, outflow/inflow composition by category and currency, and NSFR status.
- Indian specifics: Level 1 HQLA primarily cash, CRR/SLR, and G-Secs; disclosure cadence aligns with regulatory guidance; NSFR maintained on a continuous basis.
- Practice notes: align LCR and NSFR treatment with local eligibility and haircuts; reconcile regulatory vs internal stress buffers.
Section 12: Practical controls and metrics
- Controls: funding concentration caps, encumbrance limits, collateral eligibility governance, intraday dashboards, and early-warning triggers.
- Metrics: LCR, NSFR, survival horizon days, stress liquidity gap, top-counterparty share, unencumbered HQLA by level/currency, intraday usage vs limit, and repoable capacity.
- Early-warning indicators: sudden deposit outflows, CDS spread widening, collateral haircut spikes, increased utilization of central bank lines, and failed payment queues.
Section 13: Contingency funding plan (CFP)
- Triggers and stages: green–amber–red thresholds linked to metrics and qualitative signals; clear activation governance.
- Playbooks: repo against HQLA, tap term funding, securitization readiness, retail deposit campaigns, draw standby facilities, and sell-down protocols.
- Communications: coordinated messaging to staff, counterparties, investors, and supervisors; predefined templates and authorized spokespeople.
Conclusion
Effective liquidity risk management blends structural balance sheet design, robust HQLA buffers, diversified and stable funding, and precise intraday execution under a strong governance and disclosure regime. Institutions that rigorously operationalize LCR/NSFR, stress-led CFPs, and real-time intraday controls can preserve market access and resilience across idiosyncratic and systemic stress.
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