Tiểu luận assignment LIQUIDITY AND RESERVE MANAGEMENT STRATEGIES AND POLICIES

Bank uses model of demand for and supply of liquidity to determine net liquidity position at any moment in time and set the plans to use funds.. 4 Bank could increase the supply of liqui

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NATIONAL ECONOMICS UNIVERSITY

COMMERCIAL BANK

ASSIGNMENT

TOPIC:

LIQUIDITY AND RESERVE MANAGEMENT: STRATEGIES

AND POLICIES

Teacher: PhD DO HOAI LINH

Group 2 :

1 BÙI VIỆT ANH

2 PHẠM TÂM LONG

3 NGUYỄN HỮU BẢO

4 ĐỖ KHÁNH HUYỀN

5 HOÀNG PHƯƠNG QUỲNH

Ha Noi 2017

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Contents

I Liquidity risk: 3

II 2

1 Definition of liquidity of bank: 3

2 Definition of liquidity risk: According to Basel committee on Banking Supervision: The risk that a financial institution is unable to find sufficient funds to meet its maturing obligations without affecting its day-to-day business operations nor affecting its financial position 3

3 The relationship between liquidity and bank reserves: 3

4 Reason to happen liquidity risk: 3

4.1 Model of supply of and demand for liquidity: 3

4.2 The reason of happen liquidity risk: 4

III Management of liquidity risk of bank: 8

1 Signals from the marketplace: 8

2 How to prevent liquidity risk: 9

2.1 Estimating liquidity needs: 9

2.2 Principle of management and supervisor of liquidity risk 12

2.3 Prevent liquidity risk: 12

3 Control the status of liquidity of banks 14

4 The way to surmount deficit of net liquidity position: 16

4.1 First strategy 17

4.2 Second strategy: Borrowed liquidity management strategies: 17

4.3 Third strategy: Balanced liquidity management strategies: 17

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I Liquidity risk:

1 Definition of liquidity of bank:

- According to Basel committee on Banking Supervision: Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses

- => Liquidity of bank depends on the demand and supply of fund in the financial market Bank uses model of demand for and supply of liquidity to determine net liquidity position at any moment in time and set the plans to use funds

2 Definition of liquidity risk:

According to Basel committee on Banking Supervision: The risk that a financial institution is unable to find sufficient funds to meet its maturing obligations without affecting its day-to-day business operations nor affecting its financial position

3 The relationship between liquidity and bank reserves:

- When the bank falls short of liquidity, the bank's reserves will finance the deficit in the short term In addition to the cash in vault, the bank needs to reserve a premium

for this type of risk

- Liquidity risk is the type of risk mentioned in Basel II's minimum capital requirements, and needs to be carefully assessed by the bank and monitored by the

central bank

4 Reason to happen liquidity risk:

4.1 Model of supply of and demand for liquidity:

a) Supply of liquidity:

 Definition: is the amount of money that already have or going to have in the short period of time for bank in using purpose

 This cash flow comes from :

 Customer’s deposit

Considered to be the most important source of supply for the liquidity The more deposits bank has, the more liquid bank will be Bank could adjust the interest rate that attract people’s deposit

 Customer’s loan repayment

Second important of all, Lending is the main activities of bank, bring back the highest profit for bank but also come with the greatest risk -> affect the ability of payment of bank If every loans have been paid, it not just bring profit to bank but also be a great source of liquidity for bank

 Borrowing from the money market:

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Bank could increase the supply of liquidity by borrowing from the money market, including new loans, extend the due date, … borrowing from other bank and also from central bank

 Sales of assets :

- To meet the liquidity demand, bank could sell their assets

+ Revenues from the sale of nondeposit services:

- Is the amount of money that bank has received through the process of serving the customers : Opening L/C …

+ Issuing securities to the market:

 Bank issuing stocks to the market is a great source of liquidity for bank

b) Demand for liquidity:

 Definition: is the demand for withdraw the money out of bank in different time

 This demand depends on these elements:

 Demand on withdrawing the money of customers

This demand is frequent, immediately, including deposit with no terms, payment deposit and deposit with terms and can withdraw before the maturities In deposit with no term and payment deposit, bank have to secure the amount of reserve money in the account to meet the demand of withdrawing Elements that create demand of liquidity could be the rate of inflation in the economy, fluctuation in channeling funds interest rate between banks

 Credit request from customers:

This is also an element that has great influence to liquidity demand It comes from the demand of investing from investors, competitive interest rate between banks -> Harder to approach the funding sources

 Repayment of nondeposit borrowing

This is the amount of money that bank have to repay the debt from borrowing financial institution, Central bank,…

 Interest expenses:

These are costs that have to pay through mobilizing funds, interest through issuing valued paper

 Payment of stockholder cash dividends:

The amount of money that banks have to pay to their stock holders

4.2 The reason of happen liquidity risk:

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There are a lot of causes lead to liquidity risk and it comes from all sides of bank’s business activity: from subjective, objective; from the bank itself, from the customer, the policy, from the other types of risks, etc However, in terms of researching to find an effective solution to liquidity risk management, the following main reasons can be deduced:

a) Subjective reason:

 Due to the maturity of asset and liability are disproportionate, because of the converting maturity function of the bank: mobilizing short-term deposits from the public for long-term loans So asset's term is longer than liability's term, making asset's cash flow not equal to the cash flow needed to meet the maturity

of liability, causing difficulties for banks to find the source for compensation

 Risk of imbalance in asset structure

This comes mostly from the short-term profit pressure of shareholders on the board of directors, which forgot the principles of asset and liability management

In their asset portfolio, commercial banks invest in stocks and bonds, most important of which are government bonds and / or Treasury bills Although, interest rate of Government bonds and Treasury bills are not attractive but they are easy for commercial banks to discount at the central bank when occurring liquidity risk Any commercial bank, especially small banks, understands this, but with their weak financial, it is difficult to compete with big banks in the

auction of government bonds and treasury bills

 Customer structure is not reasonable

Bank just concentrates on potential customer’s credit or a proportion of one sectors, an area which occupy a large proportionof total liability Or in total mobilizing a customer having a large proportion, When these customers are having difficulty in paying off their debts on time or unexpectedly withdrawing,

this leads to an liquidity risk

 Because banks are pursuing profit targets in short term, there are overly open lending policies that lead to lower lending conditions, loans to underprivileged

borrowers As the consequence, it leads to credit risk and liquidity risk

 Because banks do not estimate the need of withdrawals or obligations to pay

When demand for withdrawing money and performing obligations exceed their expectations, these banks will face liquidity problems

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 As the financial capacity of banks is limited Charter capital is the amount of capital owned by the bank, which is formed when the commercial bank is established It reflects the scale or financial capacity of commercial banks The higher capital of the commercial banks have, the bigger potential finance of the banks are On the contrary, the lest the bank's charter capital has, the smaller the size of the bank Small banks often find it difficult to access sources of capital,

or only with high interest rates, especially for loans It can be said that there is a huge pressure when these banks have to bear the high cost to overcome difficulties in solving liquidity problem The small scale of charter capital may

be one of the reasons that pushes commercial banks to insolvency and bankruptcy when demand for liquidity increases suddenly

 Due to the multiple currency trading, it is created the liquidity risk and financing requests each currency

 Due to the reduced of bank’s prestige, the depositors quickly withdraw the deposit causing the liquidity risk This is the consequence of the weak business, the PR team has not been sufficiently invested

b) Objective reason:

 Financial assets are susceptible to fluctuations of interest rates

Interest rates change leads to a great effect of depositor’s psychology In case of rising interest rates, customers will withdraw money to deposit at other banks with higher interest rates, while borrowers will minimize new borrowing to avoid paying higher interest When interest rates fall, the reaction is reversed In both cases, fluctuations in interest rates affect both deposit and loan cash flow, ultimately affecting the liquidity of banks In addition, the change in interest rates will affect the market value of selling financial assets and the cost of borrowing

in the monetary market

 Monetary policy of the central bank

To perform its function in managing monetary policy, the central bank uses three instruments, including open market operations, reserve requirements, discount

rates and rediscount of valuable papers

- Open market operations (OMO) are the activities of central banks to buy or sell commercial banks and treasury bonds to commercial banks When wanting to increase the money supply, the central bank buys bonds from

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commercial banks, the money that the central bank pays to commercial banks increases the money supply for the economy and also increases the supply of liquidity to commercial banks On the contrary, in order to reduce the money supply, the central bank sells bonds to commercial banks, the money that the central bank collects reduces the money supply of the economy and also reduces the liquidity supply of commercial banks

- The required reserve ratio is a regulatory measure that central banks require commercial banks to maintain a minimum reserve requirement ratio at the central bank If the required reserve ratio is high then the supply of commercial banks liquidity increases and vice versa

- Discount and rediscount rates are the interest rates the central bank uses in the discounting or rediscount the value of commercial banks’ paper If this interest rate is low, this will be the cheap capital fund that commercial banks can easily mobilize to meet the liquidity demand

 Legal framework of operational safety in credit institutions system

The mechanisms, policies and legal documents related to banking operations are clearly and specifically issued as well as the operation of the bank’s supervision agency, the close coordination between “remote monitoring” and “site inspections” will contribute to ensuring the safety of the NH system

 Due to the customer's business cycle

According to seasonality at the end of year, businesses will speed up their business activities, settle debts to other companies, pay compensation to employees, make commitments to disburse money to partners, solve Inventory, import of goods creating a large demand for money in the last months of the year, which increases demand for liquidity for commercial banks

 Due to the special characteristics of the cycle business

Cycle business requires that commercial banks are always ready to meet the demand for immediate loans For other businesses, company can delay debt with customers, pay tardily with partners, even can proactively occupy the capital

of business partners But for commercial banks in the sensitive monetary, commercial banks can not delay payment Any payment delays can cause anxiety

in the public, and if the commercial bank does not solve this problem right away, the customer can go to the bank to withdraw money leads to the liquidity problem

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If this situation becomes more and more seriously, commercial banks may go bankrupt On the other hand, on the balance sheet of commercial banks, the liability always has a certain percentage of demand deposits and term deposits but can be withdrew before its maturity This is the liability that the commercial banks are obliged to pay immediately if the customer needs to withdraw, so that commercial banks are always ready to meet liquidity needs

 Due to economic crisis or financial crisis

The economic or financial crisis has led to rising costs of mobilization, reducing lending and investing efficiently On the other hand, the crisis may undermine the belief in the financial system, organizations and residents will withdraw money from commercial banks causing liquidity pressures on commercial banks

 Due to rumors

Bad rumors will lead to distrust on a particular financial institution The mechanism of imbalance between the value to be paid and the value earned from investment and lending activities will occur so that commercial banks will face liquidity risk

II Management of liquidity risk of bank:

1 Signals from the marketplace:

 Public Confidence

Institution losing money: is it because of the public perception that it will be unable to pay its obligations

 Stock Price Behavior

Falling stock price may indicate of liquidity crisis

 Risk Premiums on CDs and other borrowings

Payments of higher interest on these liabilities may be considered as risk premiums and liquidity crisis

 Loss Sales of Assets

Sales of assets in hurry (with significant losses) again may indicate of liquidity crisis

 Meeting Commitments to Creditors

Is it able to honor all requests for potential profitable loans?

 Borrowings from the Central Bank

Borrowing in large volume and more frequently from the central bank indicates liquidity crisis If problems exist in any

of these areas, management needs to take a close look at its liquidity management

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practices to determine whether changes are in order

2 How to prevent liquidity risk:

2.1 Estimating liquidity needs:

 Method 1: The sources and uses of funds approach The key steps are:

Step 1: Loans and deposits must be forecast for a given liquidity planning period Step 2: The estimated change in loans and deposits must be calculated for the

same period

Step 3: The liquidity manager must estimate the net liquid fund’s status for

planning period by comparing the estimated change in loans to estimated change

in deposits

At the first step, There are two way to estimate loans and deposits at a given liquidity planning period

The first way: Bank uses econometric models to estimate the forecast of loans and deposit by using the variables

The variables will be collected in the past of all party that take part in the process

of take deposit and make loans of bank They are variables that affect to the deposits such as income, interest rate of deposit, and the loans such as GDP, inflation, interest rate of loan,

=> - Difficult to obtain the data and deploying model

- Spend a lot of money to use the model

The Second way: Use statistics in the past of internal of bank and estimate the

forecast of sum of deposits and loans Bank divide sum of deposit and loan at any time into 3 part:

- Trend component:

Estimated by constructing a trend line using as reference points year-end, quarterly,

- Seasonal component: measuring how deposits and loans are expected to

behave in any given week or month due to seasonal factors

- Cyclical component: Representing positive or negative deviations from a

bank’s total expected deposits and loans, depending upon the strength or weakness of the economy in the current year

Sum of deposits or loans expected = sum of deposit or loans in before period + trend component + season component + cyclical component

=> Easy to collect the data and deploy model

Step 2: Calculate the change in expectation in planning period

- According to forecast model:

delta (change sum of loans) = f (GDP, interest rate of loans, inflation, ) delta (change sum of deposits) = f(income, interest rate of deposit, )

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- According to data of internal bank model:

change in loans or deposit = total loan or deposit expected in coming period - total loan or deposit in before period

Step 3: Determine the net liquidity position:

Estimated net liquidity position = estimated change in deposits - estimated change

in loans

 Method 2: The structure of funds approach:

Managers of liquidity risk only take care of demand for liquidity, do not have care about supply of liquidity The sources of fund are divided into many group, depend

on ability of withdrawal, and reserve of each group is different

Step 1: Divide fund into 3 group depend on the ability of withdrawal

- Hot money liability: deposit and other borrowed funds that are very interest sensitive

- Vulnerable funds: customer deposits of which a substantial portion

- Stable funds: funds that management consider unlikely to be removed

Step 2:

Determine reserve for liquidity of each group: Liability that has high ability of withdrawal will has high proportion, and the bank needs to hold high money for liquidity of this liability

95% to hot money liability after minus legal reserve held

30% to vulnerable funds after minus legal reserve held

15% to stable funds after minus legal reserve held

Step 3:

Estimated liability liquidity reserve:

A = 0,95 x (hot money liability - legal reserve held) + 30% (vulnerable funds

- legal reserve held) + 15% x (stable funds - legal reserve held)

Step 4:

Estimate liquidity for increase the maximum of credit operation

- Bank should hold an amount of reserve enough to increase the credit operation because of profit of bank and relationship with customer

- Bank should hold amount reserve B equal Potential loans outstanding minus actual loans outstanding

Step 5:

Estimate total liquidity requirement

Total reserve for liquidity = A + B

Step 6:

Bank use stress testing to make many scripts with many ability happen so as to estimate demand for liquidity of each script