Liquidity risk in banking sector

In banking parlance, liquidity is a financial institution's capacity to meet its obligations as they fall due without incurring losses. Liquidity risk is a risk to an institution's earnings, capital and reputation arising from its inability (real or perceived) to meet its contractual obligations in a timely manner without incurring unacceptable losses when they are due. Breaking this further down, we get mismatch risk (due to ineffective match between cash inflows and outflows, obligations cannot be met in normal course of business following sufficient cash shortage), market liquidity risk (when bank encounters market constraints when trying to convert assets into cash or to access financial market or sources of funds), and contingent liquidity risk (when unexpected events cause the bank to have insufficient funds to meet its obligations due to firm-specific factors like rating downgrade, large operational losses or external factors like severe economic slowdown, general market dislocation).
In general, a bank is said to be liquid if it is able to provide money to its customers trying to withdraw. On the contrary, a bank is said to be 'illiquid' if the customers try to withdraw more money from the bank than it can accommodate. All the scheduled banks have to manage liquidity from two perspectives. The first one is to address regulatory requirement like Cash Reserve Ratio (CRR) while the second one is to meet the contractual obligations to fulfill the demand from the depositors.
The country's banking sector had long been experiencing ample liquidity. Addressing this phenomenon, the central bank had to increase the volume of 7/14/30 day Bangladesh Bank Bills to help balance the market liquidity. However, of late, the market has seemingly been facing liquidity crunch though it still remains very much liquid at least for the very short term i.e., overnight. This is evident from the inter-bank overnight call money rate which has been hovering around 3 per cent-4 per cent on an average. Had the market been not so liquid (as opposed to 'illiquid'), the inter-bank overnight lending/borrowing rate might not stand at such a low level, if not be reached at a record high which happened in December 2010.
Banks have to keep sufficient cash in vault for meeting depositors' obligations. But practically, they do not keep all its deposits mobilised in cash for immediate withdrawal (through the counter or through ATMs). From regulatory perspective, banks are allowed to extend loan up to 85 per cent and 90 per cent of their deposits mobilised for conventional and Islamic banks (as well as Islamic window of conventional banks) respectively and therefore, 15 per cent and 10 per cent of deposits are left with them. Therefore, it is evident that a small amount of cash stocked in vault and ATMs is kept by the banks. Now, it may hardly happen that all depositors come together to withdraw their funds. This may happen only when banks face severe liquidity crunch. In such a situation, the bank, facing liquidity crunch, cannot meet contractual obligations and fails to help depositors withdraw their funds. Because, when a depositor cannot withdraw her/his fund, s/he informs other depositors that this bank is not able to provide funds.
When a bank fails to satisfy deposit withdrawal of its customers, the situation can only deteriorate. In a worst case scenario, the depositors, out of fear, rush towards the bank and start to withdraw as much as possible, leading the bank to a complete failure in meeting its obligations. This worst case situation is known as 'Bank Run'. Many incidents of Bank Run took place in Western world and some Asian countries as well. For example, in 2014, a Chinese bank suffered a three-day Bank Run after rumours of the bank turning down a cash withdrawal emerged. Supposedly, some branches remained open for 24 hours for duration of the Bank Run and tellers stacked cash behind teller windows to calm and reassure depositors.
BASEL III: With a view to strengthening the banking industry, the Basel Committee on Banking Supervision (BCBS), a committee whose secretariat is located at the Bank for International Settlements (BIS) situated in Basel city of Switzerland, framed guidelines and standards for implementation of Basel Accords (Basel I and II). These were formulated in response to deficiencies in financial regulation revealed by the financial crisis of 2007-08. The latest in the Basel Accord had been set out by unveiling 'Basel III' in September 2010 which is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
The most important feature of Basel III implementation is introduction of requirements on liquid asset holdings and funding stability, thereby seeking to mitigate the risk of a run on the bank. These requirements have been rolled out by commencing two international liquidity standards, which are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). Ideally, banks borrow for short term and lend for long term, meaning it mobilises deposits for short term and utilises these for long-term lending. Doing this, the bank has to efficiently manage its balance sheet gaps (e.g. tenor-wise gap like 1 month/3 months/6 months/1 year/2 years etc between assets and liabilities) resulting from mismatch in tenors since the outflow from maturing deposits in short term has to be accommodated whenever it fall due. Those newly implemented liquidity requirements penalise excessive reliance on short term, interbank funding to support longer dated assets so that a sound liquidity risk management is ensured.
LCR aims at promoting short-term resilience of a bank's liquidity risk profile by ensuring that it has sufficient high quality liquid resources to survive an acute stress scenario lasting one month. NSFR is to promote resilience over a longer time horizon by creating additional incentives for a bank to fund its activities with more stable sources of funding on an ongoing structural basis. Both LCR and NSFR have to be beyond 100 per cent to satisfy the regulatory requirement.
Till now, the regulator has not penalised banks which failed to keep these ratios beyond the required parameter but anytime in near future, imposition of penalty could be introduced. By only seeing these ratios, a person can determine the liquidity position of a bank. For example, an LCR of 120 per cent-140 per cent may indicate that a bank seems very strong in terms of liquidity status and in a very stress situation, it is able to withstand any kind of liquidity shock. Obviously, capital adequacy is a strong parameter in measuring a bank's financial health. But only capital position is not enough to judge the strength of a bank. During the early 'liquidity phase' of the financial crisis that began in 2007, many banks, despite having adequate capital levels, still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate, and that illiquidity can last for an extended period of time.
LIQUIDITY CONDITION IN BANGLADESH BANKING INDUSTRY: The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions. The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management.
The current liquidity condition in the banking sector is attributable to aggressive lending practices by a few of the banks. These banks' Asset Depreciation Range (ADR) has gone beyond the regulatory permissible limit. Consequently, two banks' current account with the regulator was frozen recently. This was a rare move taken by the regulator. The freezing of account put the penalised banks in a liquidity threat to some extent, besides preventing them from showing the frozen amount as CRR maintenance as well as enjoying any interest on that sum. The huge number of banks in such a small economy is racing behind customers to grab them and by doing so they are putting the industry regulation to a huge risk by breaching the lending guidelines.
The mad race among some banks has led to immoral practices, making the entire banking sector ailing. Enhanced vigilance by the regulator came as one of the new banks recently plunged into liquidity crisis, an episode that has raised questions about the continued existence of this bank. Following these incidents, the regulatory caps on ADR are likely to have a downward revision in a while to 80 per cent and 85 per cent from existing 85 per cent and 90 per cent for conventional and Islamic banks, respectively since such occurrence in a particular bank is more than enough to put the entire banking system into a reputational and most importantly, liquidity risk. This is definitely a stressful time but the banks need to try keep things on an even keel as much as possible.
It is very much clear that banks need to perform a prudent job in managing liquidity as the consequence of such inefficient liquidity risk management could pose serious threat to a financial institution and may well go beyond the ambit of any one institution to affect the entire financial system.

The writer is the Risk Manager of a foreign bank in Bangladesh.
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