Liquidity Risk Management Strategies to Secure Cash Flow

What Is Liquidity Risk?

In the context of banking institutions, liquidity is a bank’s ability to meet its cash and collateral obligations on a daily basis, without sustaining unacceptable losses. Thereby, liquidity risk refers to the bank’s inability to meet these obligations, leading to threats against its financial position or existence. In easy terms, the bank’s/ company’s or individual’s ability to pay its debts without suffering losses. Liquidity, many a time, is also used to refer to how easily an asset or security can be bought or sold in the market, or how quickly can something be converted to cash.

There are two broad types of liquidity risks: funding liquidity risk or cash flow risk and market liquidity risk or asset/product risk.

Funding liquidity risk refers to the risks that the bank cannot meet the demands of customers wishing to withdraw their deposits, whereas market liquidity risk refers to the risk of not being able to sell assets in a timely fashion without having to offer a heavy discount. Research shows that funding liquidity issues can often lead to market liquidity risk and vice versa. In this blog, we’ll be looking at strategies institutions can use to restrain funding risk or cash flow risks.

Liquidity Risk Management

A liquidity crisis, even if it only involves a single institution, doesn’t just impact the institution in question, but can have severe implications on the financial ecosystem as well as the global economy. That is why it is important for banks as well as NBFCs to have liquidity risk management systems in place. Muthoot Finance, India’s No. 1 Most Trusted Financial Services Brand, has a robust strategy in place for liquidity risk management, the fundamentals of which include:

• Liquidity Risk Management Framework, Asset Liability Management, and Risk Management Policies that have been approved by the Board of Directors are put in place to govern liquidity risk management.

• The Board of Directors has the overall responsibility of managing any risks the company may be exposed to.

• Muthoot Finance has an Asset Liability Management Committee and Risk Management Committee formed by the Board of Directors.

• The Asset Liability Management Committee reviews asset-liability profiles, funding and capital planning, preparing contingency plans, etc.

• The Risk Management Committee monitors the company’s risk profile and oversees the risk management system in place.

• The senior management has formed an Asset-Liability Committee that ensures adherence to limits set by the Board and implements the liquidity risk management strategies.

• Management regularly monitors cash and cash equivalents.

• A review of liquidity is performed regularly, and it includes financial asset and liability maturity profiles, debt financing plans, etc.

In general, it can be said that liquidity risk management is a set of processes and strategies that a bank uses to:

• Assess the ability to meet the cash flow and collateral needs.

• Mitigate risks, if any, by developing strategies and taking appropriate actions to make sure necessary funds are available when needed.

• Ensure that the balance sheet has earned the desired net interest margin, without exposing the institution to undue risks.

• Plan and structure the balance sheet with a proper mix of assets and liabilities. This helps optimize the risk profile of the institution.

• Ensure all these activities are carried out without having a negative impact on the day-to-day operations of the bank or its overall financial position.

Strategies for Liquidity Risk Management

Common examples of liquidity risk include the inability to meet the short-term debt, or unable to meet proper funding within a specific time frame among others. Here are a few strategies that can help institutions manage similar liquidity risks: -

1. Improve company cash flow management

Poor management of the bank’s cash flow can easily lead to liquidity risks, requiring the need for liquidity risk management. Proper management of the cash flow and timely actions to improve spending can help mitigate these risks.

Operational efficiency within the institutions needs to be increased, in regard to payroll, collecting customer payments, paying expenses and debts. Simultaneously, management can make future planning for investments, purchase of new equipment, etc. Banks can also aim for accurate cash flow projections to improve cash flow.

2. Improve risk reporting abilities

Banks and financial institutions need to understand that reporting risks needs to move forward with the advent of technology and software, that can streamline the financial data and help ease the process from a bigger standpoint. Upgrading to software will make the task easier, faster, efficient and more transparent. Managing liquidity risk in banks does not have to be limited to individual spreadsheets and tallying of insights to identify potential risks.

3. Improve balance sheet management

Using software to manage balance sheets allows banks to analyze and plan budgets and capabilities, to maintain positive balance sheets. Apart from reducing liquidity risks, it also helps accumulate a wide pool of data, from multiple sources, which can then give a real-time view of the bank’s assets, liabilities, and shareholders’ equity. This can help the banks to respond immediately to any potential risks and stay on top of both their long-term and short-term obligations.

4. Improve risk metrics and monitoring processes

Revisiting metrics that are in place to identify risks and reworking on their context is also a proven strategy for liquidity risk management. By rolling out the formal monitoring processes, and constantly keeping them regularly updated, banks can secure cash flow and rule out potential risks, if any.

5. Prepare better for stress

In order to prevent risks and losses, it is vital that banks are able to first identify their risks well. They need to be honest about the possibility of extreme situations unfolding, consider the worst possible scenario and then work towards creating a solution to prevent it. If they aren’t only aware of what can hit them, they’ll end up with heavy losses.

Undergoing regular financial stress tests is an answer here, which help to identify and deal with both short-term and long-term liquidity risks. Stress tests simulate institution-related problems as well as market-wide problems which can be assessed for risk tolerance.

Liquidity and markets are subject to evolution and the strategies to help us get out of the puddle also need to evolve with time. The methods that worked a decade ago might not work anymore in the current situation and that is why it becomes very important to ensure risk management strategies are regularly updated. Several banks and NBFCs like Muthoot Finance publish regular disclosures on their liquidity risk, that anyone can check online.