November 25, 2012

MA0042 [Treasury Management] Set2 Q2

Q.2 What is liquidity gap and detail the assumptions of it?

Ans:

A liquidity gap is the difference between the due balances of assets and liabilities over time.

At any point of time, a positive gap between assets and liabilities is equivalent to shortage of cash. The marginal gap refers to the difference between the changes of assets and liabilities over time. A positive marginal gap means that the change in the values of assets exceeds that of liabilities. The gap profile changes as and when new assets and liabilities are added. The gap profile is represented either in the form of tables or charts. All the assets and liabilities are accounted in liquidity gap report and it is dependent on the dates of maturity and the actual date.

Alternative scenarios
Alternative scenario method is used to calculate the adequate liquidity in banks. Depending on the behaviour of cash flow the alternative scenario calculates a banks liquidity in different conditions.

There are three scenarios for a bank that provides useful benchmarks. They are:
Going concern
Bank specific crisis
General market crisis

A bank should try to account for any major liquidity changes (positive or negative) that could occur in these scenarios.

Going concern/general market conditions
The going concern/general market conditions scenario is helpful for banks in establishing a standard for the normal business behaviour. Banks use general market conditions to handle the deposit and other debts. With the help of general market conditions the banks avoid the impact of temporary constraints and manage their NFRs. Due to this concern, the banks never face a very large need of cash to be paid on any given day.

Bank specific crisis
The bank specific crises are liquidity crises for individual banks. The crises remain restricted to the banks and provide a sort of worst-case benchmark. The main idea in bank specific crisis is that, the banks liabilities cannot be replaced or rolled over. The banks must pay the liabilities at the time of maturity. If a bank can survive these types of worst-cases, then the bank can survive any kind of small problems.

General market crisis
The general market crises are the ones under which liquidity affects every bank in more than one market. Some banks might think that the nations Central bank would ensure that the key markets would continue to function in some form. For bank management, the scenario represents a second type of "worst-case". While surveying the liquidity profile of entire banking sector, the Central bank might find this scenario to be of particular interest. The combined results will suggest the size of the total liquidity buffer in the banking system. The result also suggests the likely distribution of liquidity problems among large institutions.

A bank needs to assign the time for cash flow for each category of asset. The decision about the exact time and size of cash flows is an essential part of the construction of the maturity ladder under every situation.

Assumptions in preparation of gap report in terms of assets, liabilities and off balance sheet items.

Since the future liquidity position of a firm cannot always be predicted based on the factors, assumptions play an important role in determining the continuing due to the rapidly changing banking markets. But the number of assumptions to be made should be limited. The assumptions can be made based on three aspects. They are assets, liabilities, and off-balance sheet assets.

Assets
Assets are nothing but any item of economic value owned by an individual or corporation. Assumptions regarding a banks future stock of assets include their possible marketability and use an asset as a guarantee of existing assets which could increase flow of cash and others.

To determine the marketability of an asset, the method segregates the assets into three categories according to their degree of relative liquidity:

The highly liquid group of assets consists of components such as interbank loans, cash and securities. Some of the assets might instantaneously be converted into cash at existing market values under almost any situation whereas others, such as interbank loans might lose liquidity in a common crisis.

A less liquid group of assets consists of bank's saleable loan portfolio. The assignment here is to develop assumptions about a reasonable plan for the clearance of a bank's assets. Some assets, while marketable, might be viewed as unsaleable within the time frame of the liquidity analysis.

The least liquid group of assets consist of basically unmarketable assets such as loans that are not capable of being readily sold, bank premises and investments in subsidiaries.

Because of the difference in the banks internal asset-liability management, different banks can allot the same assets to different groups on maturity ladder.

While categorising the assets, banks should take care of the effects on the assets liquidity under the various conditions. Under normal conditions, there may be assets which are much liquid then during a time of crisis. Therefore a bank may classify the assets according to the type of scenario it is forecasting.

Liabilities
To check the cash flows occurring due to a bank's liabilities, a bank should first examine the behaviour of its liabilities under normal business situations. This would include forming:

The level of roll-overs of deposits and other liabilities remain normal.

The actual maturity of deposits with non-contractual maturities, such as demand deposits and others; the normal growth in new deposit accounts.

While examining the cash flow arising from a bank's liabilities during the two crisis scenario, a bank would look at four basic questions. The first two questions represent the proceedings in the flow of cash that tend to reduce the cash outflows planned directly from contractual maturities. 

The four questions are as follows:
What are the different sources of funding that are likely to stay with a bank under any situation, and can the count of these sources be increased?

Other than the liabilities identified from this step, a bank's capital and term liabilities that are not maturing within the prospect of the liquidity analysis provide a liquidity buffer.

The total liabilities identified in the first category may be assumed to stay with the bank even when its a worst scenario. Some core deposits generally remain with a bank because retail and small scale industry depositors may rely on the public-sector security net to shield them from occurring loss, or because the cost of changing banks, especially for some business services that include transactions accounts, is unaffordable in the very short term.

What are the sources of funding that can be estimated to run off gradually if problems occur, and at what rate? Is deposit pricing a way for controlling the rate of runoff?

The second category consists of liabilities that have chances of staying back with the bank during the period of slight difficulties and can be used during crisis. Liabilities, includes core deposits that are not already included in the first category. In some countries, other than core deposits, some of the interbank deposits and government funding remains with the bank even though they are considered volatile .for these kinds of cash flows a bank's very own past experience related to liabilities and the experiences of other such firms with similar problems may come handy. And help in creating a time table.

Which maturing liabilities can be estimated to run off instantly at the first warning of trouble?

The third category consists of the maturing liabilities that remained, including some without contractual maturities, such as wholesale deposits. Under each case, this approach adopts a conservative stand and assumes that these remaining liabilities will be paid back at as early as possible before the maturity date, especially when there is high crisis, as such money may flow to government securities and other safe refuges.

Factors such as diversification and relationship building are considered important during the evaluation of the degree of the outflow of funds and a bank's capacity to replace funds. Nevertheless, in a general market crisis, sometimes high scale firms may find that they receive larger than the usually got wholesale deposit inflows, even though there are no cash inflows existing for other firms in the market.

Does the bank have a reliable back-up facility?

For example, small banks in local areas may also have credit lines that they can bring down to offset cash discharges. These facilities are rarely found in larger banks but however it depends on the assumptions made on the banks liabilities. Such facilities usually need to undergo many changes but only to a limit, especially in a bank specific crisis.

Off balance sheet item
A bank should also examine the availability of sufficient cash flows from its off balance sheet activities (other than the loan commitments already considered), even if they are not a portion of the banks recent liquidity analysis.

In addition, the Contingent liabilities, such as letters of credit and financial guarantees, represent potentially significant cash outflow for a bank, but are usually not dependent on a bank's condition. A bank may be able to create a "normal" level of out flow of cash on a regulatory basis, and then estimate the possibility a raise in these flows during periods of stress. However, a general market crisis may generate a considerable increase in the total invocation of letters of credit because of an increase in defaults and liquidations in the market.

Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options, and forward foreign exchange rate contracts. For instance, consider that a bank has a large swap book; it would then want to study the circumstances under which it could become a net payer, and whether or not the total net pay-out is significant.

Consider another situation wherein a bank acts as a swap market-maker, with a possibility that in a bank-specific or general market crisis, customers with in-the-money swaps (or a net in-the-money swap position) would try to reduce their credit exposure to the bank by requesting the bank to buy the swaps back. Similarly, a bank would like to review its written OTC options book and any warrants that are due, along with hedges if any against these positions, since certain types of crises sometimes arouse an increase in early exercises or requests that the banks should buy the offer back. These activities could result in an unexpected cash loss, if hedges can neither be quickly liquidated to generate cash nor provide insufficient cash.

Other assumptions
Until now the discussion was centered on the assumption about the behaviour of the specific instrument under different scenarios. At the time of looking the components exclusively, there might be some of the factors that might have a major impact on the cash flows.

The need for liquidity arises from business activities. The banks too need excess funds to support extra operations.

For example, the majority of the banks provide clearing services to financial institutions and correspondent banks. These institutions generate a major sum of cash inflow and cash outflows and unpredicted variations in these services can reduce a banks funds to a large extent.

The other expenses such as rent and salary however are not given much importance in the analysis of the banks liquidity. But they can be sources of cash outflows in some cases.

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