In the realm of liquidity risk in the Banking Sector of Bangladesh
In banking parlance, liquidity is a financial institution's capacity to meet its obligations as they fall due without incurring losses and liquidity risk is the risk to an institution's earnings, capital & reputation arising from its inability (real or perceived) to meet its contractual obligations in a timely manner without incurring unacceptable losses when they come 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 the bank is able to provide money to its customers trying to withdraw and 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. First one to address regulatory requirement like Cash Reserve Ratio (CRR) while the second one to meet the contractual obligations to fulfill the demand from the depositors. The country's banking sector had long been experiencing with ample liquidity. Addressing to this phenomenon Central Bank had to increase the volume of 7/14/30 day Bangladesh Bank Bills to help balancing the market liquidity. However, of late, the market has seemingly been facing liquidity crunch, though the market still remains very much liquid at least for the very short term i.e., overnight.
This is evident from the interbank overnight call money rate which has been hovering around 3%-4% on average. Had the market been not so liquid (as opposed to name it as 'illiquid'), the interbank overnight lending/borrowing rate might not stand at such low level, if not be reached at the record high level which happened during December 2010! Addressing to meet depositors obligations banks have to keep sufficient cash in vault.
But practically banks do not keep all of its deposits mobilized in cash for immediate withdrawal (through the counter or through ATMs). From regulatory perspective banks are allowed to extend loan up to 85% and 90% of their deposits mobilized for Conventional and Islamic (including Islamic window of Conventional banks) respectively and therefore, 15% and 10% of deposits are left with them.
Therefore, it is evident that a small amount of cash stocked in vault and ATMs are 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 failed to provide depositors intend to 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 deposits 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 obligation. This worst case situation is known as "Bank Run". There are many incidences of Bank Run that took place in western world and some Asian countries as well. As an example in 2014 a Chinese bank suffered a three-day bank run after rumors of the bank turning down a cash withdrawal transaction emerged. Supposedly, some branches remained open for 24 hours for the duration of the bank run, and tellers stacked cash behind teller windows to calm and reassure depositors!
With a view to strengthen the banking industry Basel Committee on Banking Supervision (BCBS), a committee whose secretariat is located at the Bank for International Settlements (BIS) in Basel of Switzerland, framed guidelines and standards for implementation of Basel Accords (Basel I and II) in response to the deficiencies in financial regulation revealed by the financial crisis of 2007-08.
The latest in 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 implementation set out in Basel III is through introducing 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 short and lend long i.e., it mobilizes deposits for short term and utilizes 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 the mismatch in tenors since the outflow from maturing deposits in short term has to be accommodated whenever fall due. Those newly implemented liquidity requirements penalize excessive reliance on short term, interbank funding to support longer dated assets so that a sound liquidity risk management is ensured.
Objective of LCR is to promote 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 for one month while 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% to satisfy the regulatory requirement. Till now the regulator has not been penalizing the banks 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%-140% 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 level 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.
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 few of the banks. These banks' ADR have gone beyond the regulatory permissible limit. Consequently two banks' current account with the regulator has been frozen recently, a rare move taken by the regulator. This freezing of account put the penalized banks in a liquidity threat to some extent, besides thwarting 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 amongst the old and new generation banks has led to immoral practices, making the entire banking sector ailing. Enhanced vigilance by the regulator comes 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% and 85% from existing 85% and 90% 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 keeping things on an even keel as much as possible.
In a nutshell, it is very much clear that banks need to perform a prudent job in managing liquidity and self preservation should not be the only impetus, 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 single institution to affect the entire financial system.
Source: https://dailyasianage.com