Back to basics

It is not possible to use standard liquidity ratios for liquidity management for the following reasons:

The adequacy of a bank's liquidity will vary.

In the same bank, at different times, similar liquidity positions may be adequate or inadequate depending on
anticipated or unexpected funding needs.
Likewise, a liquidity position adequate for one bank may be inadequate for another.

Determining a bank's liquidity adequacy requires an analysis of the current liquidity position, present and anticipated
asset quality, present and future earnings capacity, historical funding requirements, anticipated future funding needs,
and options for reducing funding needs or obtaining additional funds.
Developing Liquidity Scenarios
The impact of shrinking liquidity can clearly be seen from the attached graphic, which highlights the fact that all risks
have a direct and tangible bearing on liquidity. If an organisation manages liquidity, it essentially is managing its survival.
Liquidity is governed by both internal and external factors, and these should be analysed for any liquidity issues that
may arise in the next 30-60 days.
These indicators are not a complete list, but are generally useful in assessing the banks overall cashflow and liquidity
profile, key cash inflows and outflows, and the impact of these on the banks cash management policies.
Some of the key indicators that need to be reviewed for liquidity are:
Widening funding spreads
Increased usage of limits
Temporary funding difficulties, or rejected borrowing requests
Increased dependency on best funding sources
Difficulty finding new funding sources at the same or similar rates
Decline of stock prices relative to peers
Downgrades
Steady and tangible decline in earnings
Increase in level of non-performing assets
Significant asset growth or acquisitions
Pressure to buy back liabilities or support market
Successive quarterly losses
Continual growth of problem loans and loan losses
Successive ratings downgrades
Significant change in customer behaviour

Each of these indicators should then be quantified with a set of reports relating to:
Cash flows or Maturity Ladder
Customer deposits and customer behaviour
Anticipated draw-downs
Limit utilisation
Low cost funding
Alternative sources of funding
Off-balance sheet commitments
Each of these reports provide a clear understanding of the organisations funding and lending needs, and produces a
comprehensive framework for modelling cashflow routines for liquidity management needs. Without these, an
organisation would surely suffer a liquidity crisis sooner rather than later.
A set of standard scenarios should be developed and run daily and the results can then be assessed as follows:
This will ensure that on any given day, the organisation is looking at its liquidity position; its maximum cumulative cash
outflows are analysed based on not just contractual obligations but also customer behaviour characteristics, and the
organisation assesses its non-determinant maturity deposits on a consistent basis. Liquidity results can thereafter be
stress tested as follows:
Note that the stress tests take into consideration new business and rollover forecasting assumptions and therefore
provide a more meaningful review of cashflow dynamics.
Liquidity goals, as a minimum, must encourage the following:
Increase customer funds
Decrease dependence on
Interbank
Intergroup
Large Funds Suppliers
Cross Currency Funding
O/N Funding
Liquidity reporting as a minimum must include the following:
Analysis of funding requirements
Limit application and excess reports
Satisfy regulatory requirements (BIS, OCC, others)
Concentration Risk analysis - volume, mix (investor, product, industry)
Liquidity Ratios
Contingency Funding Plans
Attention must be paid to alternative sources of funding, particularly to avoid the re-occurrence of a Northern Rock-like
concentration risk.
According to their own financial statements, As at 30 June 2007 around 75% of Northern Rocks total funding was
sourced from the non-retail money markets with 53.8 billion of their total non-retail funding balances of 80.5 billion, i.e.
two thirds, raised from securitisations and covered bonds.
This risk can be diversified away with a more active foray into the customer-behaviour driven retail deposits world.
Key Next Steps
Regardless of the method or combination of methods chosen to manage a bank's liquidity position, it is of key
importance that management formulates a policy and develops a monitoring system to ensure that liquidity needs are
met on an ongoing basis.
A good policy should generally provide for forward planning which takes into account the unique characteristics of the
bank, management goals regarding asset and liability mix, desired earnings, and margins necessary to achieve desired
earnings.
Forward planning should also take into account anticipated funding needs and the means available to meet those needs.
The policy should establish responsibility for liquidity and funds management decisions and provide a mechanism for
necessary coordination between the different departments of the bank.

This responsibility may be assigned to a committee. Whether the responsibility for liquidity and funds management rests
with a committee or an individual, strategies should be based on sound, well-deliberated projections.
The board of directors and the examiner should be satisfied that the assumptions used in the projections are valid and
the strategies employed are consistent with projections.
The future of financial institutions is fraught and in these troubled times, the onus on survival cannot be left to the
regulatory watchdog, but instead, organisations should be blood-hound like in actively managing key risk areas, of
which liquidity is the most prominent.
The days of patting oneself in the back on account of higher than required capital adequacy are not just numbered, they
are a thing of the past, and the only way forward is self-regulation.
[1] http://www.bis.org/publ/bcbsca.htm
[2] Audited financial statements as on 31 December 2007
The views expressed in this column are the author's own and do not necessarily reflect this publication's view,
and this article is not edited by Asian Banking & Finance. The author was not remunerated for this article
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