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Managing Risks in Commercial and Retail Banking by AMALENDU GHOSH

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CHAPTER 17

Liquidity Risk Management

17.1 LIQUIDITY RISK CAUSES

Liquidity refers to the ready availability of cash and cash-like liquid assets with the bank to meet payment obligations and fund assets. Liquidity risk is the risk of the bank's inability to garner liquid funds to meet liabilities and other commitments as and when they arise. The demand for liquid funds arises on account of the following obligations:

1. To make payments on deposits, borrowings, and other liabilities.

2. To fund loans and advances.

3. To settle claims against the bank.

4. To honor contingent liabilities that devolve on the bank out of contractual obligations.

Provision for adequate liquidity in a bank is crucial because a liquidity shortfall in meeting commitments to other banks and financial institutions can have serious repercussions in the money market and endanger the stability of the financial system. Failure to meet customer payments in time in one location may have a chain reaction across other places of operation of the bank, and in a worse situation, may cause a run and threaten its solvency. This type of incident, even if temporary, damages the bank's reputation and erodes customer confidence.

Liquidity is a continually changing variable, and the volume of liquid assets needed to maintain operational flexibility goes on changing daily. The level of optimum liquidity that a bank needs to maintain is dependent on a number of factors. Adequate liquidity does not mean maintenance of excess ...

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