We consider liquidity management as the linchpin of any and every financial sector. Financial institutions like banks are often evaluated on their liquidity, or their capacity to meet cash and collateral obligations without provoking sizeable losses. So, in this blog, we will discuss liquidity management and its objectives.
What is Liquidity?
We can refer to liquidity as the degree to which an asset or security can be bought and sold in the market without affecting its market price. Cash is considered as the most liquid asset universally, as we can convert quickly and smoothly into other holdings.
What is Liquidity Management?
Liquidity management refers to the ongoing and future strategies of any business to meet its short-term or immediate cash requirements without incurring substantial losses. It also ensures timely access to cash or liquid funds whenever needed. Therefore, liquidity management in banks is a crucial activity as it affects the viability of their assets and risk management capability.
How Do Banks Achieve Liquidity?
Banks dabble in substantial capital market businesses to support repo agreements, prime brokerages, and other financial activities to earn revenues and profit. Hence, they have added complexity in their liquidity requirements. Listed are some of the ways by which banks achieve liquidity:
- Shorter Asset Maturities: Shorter maturity assets are said to be more liquid. There is also a direct benefit if they shorten it to an extent where the resources mature throughout a cash crunch. This will help banks in meeting their short-term liquidity needs or cash crunches.
- Improve The Average Liquidity Of Assets: Usually, securities tend to be more liquid than loans or other holdings. And short-term maturity assets can be easily liquidated as compared to long-term assets. Thus, securities dispensed in extensive volume and by formidable enterprises, have greater liquidity because they have more creditworthiness than other lesser-known securities.
- Lengthen Liability Maturities: If the term of liability is longer. Then less it is expected to mature while the bank is still in a cash crunch.
- Reduce Contingent Commitments: Reduction in the contingent commitments to pay out cash in the future limits the potential outflow. That reconstructs the balance of sources and usage of money.
Principles of Liquidity Management
According to document no. 69 dated February 2000 of The Bank for International settlements’ Basel Committee, these are the main principles that banks should adopt for effective liquidity management:
1. Banks Need To Develop A Structure For Liquidity Management
- Banks should have an acknowledged procedure for day-to-day liquidity management. They should communicate this strategy throughout the company.
- A Governing board should approve of this and other notable policies related to liquidity management.
- There should be a management structure in place to implement the strategy.
- Adequate information systems must be available in banks for measuring, observing, controlling, and reporting liquidity perils.
2. Banks Need To Measure And Control Net Funding Requirements
- Banks must validate a process for the ongoing analysis and monitoring of the net funding requirements.
- They should examine liquidity by employing a combination of scenarios.
- They should also periodically review the assumptions used in managing liquidity to conclude that they continue to be valid.
3. Banks Must Manage Market Access
Banks should regularly evaluate their efforts to maintain relationships with liquidity holders. The aforementioned is done to sustain the diversification of liabilities and intends to guarantee its capacity to sell assets.
4. Banks Must Have Contingency Plans
Banks should have emergency plans in place that addresses the strategy for managing liquidity crises. The approach should include procedures for making up cash flow shortfalls in necessities.
5. Banks Need To Manage Their Foreign Currency Liabilities:
- Banks must have an estimating, tracking and controlling system for its liquidity areas in the main currencies in which it is active.
- An adequate system for internal controls over its liquidity risk management process must be in place.
- There should be a mechanism in place that ensures a sufficient degree of divulgence of information about the bank. That is to manage the public perception of the business and its soundness.
Cash And Liquidity Management
Banks adopt the following ways to manage currency and liquidity in the establishment:
- Cash is complete liquidity. It consists of cash-in-hand, held by the bank or deposited with Central Bank (RBI).
- They regulate the amount of cash to be kept by a bank by statutory provisions. Establishments identify these provisions as Statutory Liquidity Ratio (SLR) and Current Reserve Ratio (CRR).
- In addition to this, the practical expertise of bankers also plays an indispensable role. They help in deciding the quantum of cash to be kept as cash in hand.
- Hence every bank must adopt a system of total cash management to measure and regulate the liquidity needs.
- Particular guidelines are in place for investment by banks.
- Furthermore, cash management is also subject to SLR and CRR measures.
3. Loans and Advances
- Commercial Banks function as financial intermediaries.
- They gather funds via numerous deposit schemes and, a generous portion of these funds extends as bank credit in several sectors of the economy.
- In a way, banks also operate as a trustee of savings and idle funds of the society.
- The quality of the credit portfolio determines their capability of discharging their duty. Providing loans to different sectors of society are the best-suited method of managing excess cash by banks as this sector is more secure than investing in the capital market.
Financial health is of utmost importance for any and all businesses. And banks are inherently sensitive when it comes to not having enough margins of safety and profit. Managing liquidity in banks helps assess the final performance, calculate the cash flow and eliminate any other liquidity risks. Therefore, liquidity management in banks is imperative for the proper functioning of the organization.