Managing risks for businesses is a continuously evolving process that requires a clear understanding of the entity’s objectives. The achievement of objectives set out by the businesses requires the implementation of processes through different functions. The outcomes from an action or event could result in adverse impacts either resulting in a direct loss of earnings or may result in the entity’s inability to meet its objectives. These outcomes pose risks that could limit the company’s progress and may result in either expected losses which may be known with reasonable certainty or unexpected losses. The type and degree of risks may depend upon factors such as organization size, structure, business activities, complexity, industry, and many others.
Financial institution’s activities encompass risks at strategic, macro, and micro levels which require risk management to optimize risk-reward trade-off and on a broader aspect minimize risks. Also, the products and services offered by financial institutions are ever-changing imposing greater challenges for the management to ensure that the regulatory framework is sound to manage risks. These risks need to be assessed and measured not in isolation in order to control them in an efficient manner. Financial institutions face various risks such as market, credit, liquidity, and operational risks.
The liquidity of an asset is assessed from its readiness and convertibility to cash or near asset through buying and selling without loss in the value. It is also referred to as marketability. The higher the marketability of an asset the higher is the liquidity. Financial institutions act as intermediaries between different parties. A typical balance sheet of financial institutions particularly financial institutions depicts two main activities to accept funds through deposits (liabilities) and to grant loans (assets).
A financial institution utilizes funds/deposits to finance its assets. However, a financial institution may not invest its funds completely in loans and may either keep some funds as cash or reserves at a central financial institution or invest in other instruments (Alger & Alger, 1999). The firm’s demand for liquid assets depends upon the value they will deliver once cash is required to meet their liquidity requirement. Financial institutions participate through primary and second markets to purchase or sell different financial instruments including government securities, corporate bonds, debt instruments, capital securities, and other interest-bearing financial instruments.
There is a trade-off between risks and rewards in financial institution’s decisions regarding the placement of funds. The inverse relationship between risk and yield indicates greater return from financial institution’s financing activities as compared to investments in said financial instruments. However, financial institutions still invest in certain financial instruments despite lower returns. These financial instruments include government securities and blue-chip securities. The yield foregone by financial instruments may be justified by an understanding of risks associated with investing in non-liquid assets.
Financial institutions face liquidity risk which is the risk of financial loss to an institution arising from its inability to fund increases in assets and/or meet obligations as they fall due without incurring unacceptable costs or losses (OECD, 2006). Furthermore, it is the risk that the investor will have to sell a bond below its true value where the true value is indicated by a recent transaction (Fabozzi, 2000).
The liquidity problem may also be viewed as not possessing or acquiring sufficient funds to meet the financing requirements of a project. Liquidity risk can impose a catastrophic effect on the financial institutions as this can have a negative impact on earnings and capital from its inability to timely meet obligations when they come due without incurring unacceptable losses and in a worst-case scenario it may cause the collapse of an otherwise solvent institution.
The liquidity risk for financial institutions arises when the holding of liquid assets is not able to meet its obligation. In order to avoid such situations, financial institutions maintain a liquidity level by investing and managing a balanced investment portfolio. The financial institutions maintain a liquid portfolio by maintaining a certain level of cash or cash equivalents either as an investment in treasury bills or special currency reserves with the central financial institutions. However, finding the right balance of asset liabilities is a problematic issue and financial institutions require to implement systems that ensures that they fall back in liquidity levels can be controlled
There are various reasons why financial institutions become subject to liquidity problems. The liquidity crisis may be triggered by event-driven sources, transaction/product-driven sources, and market trends. These can arise from incorrect judgment and complacency by the management regarding liquidity, drop-in business reputation, unanticipated change in the cost of capital, abnormal behavior of financial markets, risk-activation by secondary sources, breakdown of the payments system, macroeconomic imbalances, contractual form, and financial infrastructure deficiency (Jean, 2000).
The financial institutions based on the assumptions regarding the market and their own structure and procedures develop a liquidity management policy that ensures their ongoing progress and sustainability. However, estimating the outcome of each decision made by the company is not possible under the shifting conditions internal and external to which they are exposed to. Financial institutions considered to have relatively high exposure to liquidity risk are those with large off-balance sheet exposures (e.g. commercial papers, loan commitments, derivatives, interbank borrowing & lending, etc.) or those which are relying extensively on large corporate deposits.
Furthermore, rapid growth in the institutions’ assets may impose greater risks that they may face a liquidity crunch. The recent sub-prime loan crisis in the U.S.A. market deteriorated the values of assets held by financial institutions due to payment issues and sell-off at lower market values leading to liquidity problems and causing a decline in their stock values (Laird, 2007). This also implies that the liquidity risk analysis cannot be carried out in isolation as financial risks are not independent and liquidity problems can be triggered by market, credit, strategic risks, etc.
In situations of a liquidity crisis, the rating of the financial institutions may be adversely affected and they often seek to meet their liquidity requirements from the market. Governments adopt intervening policies through their central bank function or utilize/sell off their reserves of valuable commodities to support the institutions or markets which face extreme liquidity problems.
Financial institutions should develop methodologies to indicate early warnings signs which may not always lead to liquidity problems but may ignite such problems. These indicators may include e.g. increased concentrations in either assets or liabilities, declining quality of a credit portfolio, a negative trend in earnings performance or projections, funding based on volatile large deposits, higher off-balance sheet exposure, and weakening third-party evaluation about the institution.
The liquidity analysis of an institution requires determining sources of funding and accessibility to these sources. This will require understanding the nature of those markets in which businesses operate as the ability to solve liquidity issues depend upon the characteristics of such markets including its participants and terms and conditions and its perceptions and assessment of the financial institution.
The financial institution of International Settlements (2000 & 2008) laid down its principles regarding the management of liquidity risks. These principles focus on developing a uniform understanding and adaptation by financial institutions worldwide. These principles laid out guidelines for establishing an integrated liquidity risk management framework with an objective to raise financial institution’s ability to meet liquidity requirements. These principles covered risk toleration and governance, strong management, measurement of liquidity risk, contingent planning, alignment of risk-taking business units, management of market access, foreign currency exposures, and appropriate quantitative and qualitative disclosures.
As liquidity risk is due to uncertain asset and funding liquidity, financial institutions and corporation develop different approaches for assessing, measuring, and handling situations of a liquidity crisis. Various asset-liability management methodologies have been developed which may include cash flow projections, stress and scenario testing, contingent funding planning. The liquidity policy should define supervisory roles and a comprehensive liquidity risk strategy should pronounce specific rules and regulations to ensure that liquidity objectives are achieved.
These include issues regarding the composition of assets and liabilities, diversification and stability of liabilities, and financial market access. However, it is widely accepted that balance sheets of different organizations differ significantly therefore there is little standardization in how such analyses should be carried out. However, amongst different sector practices and policies have been established, enforced, and followed to ensure that stakeholders are protected.
References
Alger, G. & Alger, I. (1999). Liquid assets in banks: theory and practice. Boston College Working Papers in Economics. Web.
Basel Committee on Banking Supervision. (2008). Principles for sound liquidity risk management and supervision. Bank for International Settlements. Web.
Basel Committee on Banking Supervision. (2000). Sound practices for managing liquidity in banking organizations. Bank for International Settlements. Web.
Fabozzi, F. J. (2000). The handbook of fixed income securities. McGraw-Hill Professional, ISBN 0071358056, 9780071358057. Web.
Jean, T. (2000). Liquidity and risk management. Journal of Money, Credit & Banking. Web.
Laird, C. (2007). World liquidity crisis emerging. Prudent Squirrel. Web.
Organization for Economic Co-operation and Development. (2006). Credit risk and credit access in asia. OECD Publishing, ISBN 9264035974, 9789264035973. Web.
Scott, D. L. (2003). Wall street words: an A to Z guide to investment terms for today’s investor. Houghton Mifflin Reference Books, ISBN 0618176519, 9780618176519. Web.