Liquidity Risk Management

Due to combined effect of several other risks, the bank suffered severe liquidity crisis. They could not meet the margin calls from Singapore Monetary exchange and Osaka stock exchange. In fact they had already remitted USA Dollars 1189 million to meet their Dealers demand without any worthwhile questioning. The bank had to close down its operation.

Liquidity risk can also be caused by credit risk when a counter party will not settle for full value at due date (May do so at a later date unspecified). The party facing default, has to finance the short fall, at short notice. Some times the defaulting parties may with hold payment even if is not insolvent causing the lending bank to scramble for funds. This is a case of liquidity risk unaccompanied by credit risk.

Short term liquidity

Short term liquidity (Funding) crisis may most likely result from a shock to the financial system, either internal or external, which disrupts the orderly funding operations. Such crisis can be temporary needing no changes to credit ratings. This disruption may last for a duration of over night to 3 months.

As part of managing this short term liquidity risks it is suggested that

a. The treasury management may prepare additional liquidity work sheet.

b. Discuss in the ALCO the short term sources of liquidity available in the market

c. Locate short term investor source.

d. Identify un-encumbered securities to pledge and borrow from. Credit and treasury department to co-ordinate fund raising efforts.

Short term sources, Long term sources, short term uses, long term uses in between them if mismatches occur there is bound to be liquidity problem necessitating immediate correction of either raising funds or investing with out loss of interest.

The key ratios that are relevant to be addressed are:

1. Loans to Total assets

2. Loans to core deposits

3. Large liabilities to Earning assets (After netting out the temporary investments)

4. Purchased funds (Inter bank, money market borrowing, C.O.D, Institutional deposits) to total assets

5. Loan losses to net loans

Long term liquidity

Long term funding crisis would occur most likely as a result of drastic credit deterioration unless the grant of Long term loans themselves funded out of short term sources.

This phenomenon was typical in almost all the Euro finding, off-shore finances, Joint venture projects, and participation in syndicated loans by banks in India. All most all the banks were in a similar trap, when default occured, currency and exchange crisis surfaced, De-valuation, Revaluation took place in a few currencies like U.S.Dollar, Swiss francs. Japanese yen and Indonesian currency. and of few other developing nations, and countries like Nigeria, Argentina, other Latin American countries with a fanned inflationary conditions and destabilized economic conditions. Neither the financing banks nor the joint venture promoters from India were familiar with nature and type of risks they will be exposed to, though they were well-known Industrialists of some repute locally in India.

Short term deposit taking at viable rates are not usual in the countries we operated. Six monthly roll over at LIBOR plus Add on was the major source of funding long term fund requirements of these projects. When the projects suffered, and default occurred the roll over obligation was entirely on the financing banks. Due to combined and cumulative effect of several factors indicated banks stood badly exposed. The principal liability and installments payable got ballooned and the promoters faced huge liability as the projects generated local currency revenues except in the case of export oriented units. Due to the local currency devaluations during the projects initial pay back period the borrowings got multiplied. While conversion under multi-currency option was exercised there were further ballooning effect.