LIQUIDITY RISK ANALYSIS AT FINANCIAL- BANKING INSTITUTIONS

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1 LIQUIDITY RISK ANALYSIS AT FINANCIAL- BANKING INSTITUTIONS Prof. Constantin ANGHELACHE PhD Bucharest University of Economic Studies / Artifex University of Bucharest György BODÓ Ph.D Student (gyorgy.bodo@yahoo.com) Bucharest University of Economic Studies Abstact In the banking system, in the context of total risk and risk categories, liquidity risk is a very important one. The ability to initiate fi nancial operations and to complete them in the short term with minimal costs and high profi tability depends on the liquidity of the fi nancial and banking institution concerned. The liquidity risk, being considered as the probability of loss, partial or total, of the fi nancing capacity, can have important negative effects. Bank liquidity elements can be identifi ed, known and based on valuation indicators to determine the liquidity risk, such as intensity, depth and duration. In this respect, in bank management, special attention must be paid to identifying the premises for its occurrence and, in this way, to provide for measures to prevent or, at least, to limit the effects of liquidity risk. Indicators, such as liquidity ratio, liquidity index, loan / deposit ratio, and others, offer the ability to permanently monitor the degree of liquidity, on the basis of which the prospect of liquidity risk may be identifi ed. Of all the banking risks, liquidity has the most profound and immediate effects on the stability of the bank considered. Key words: banking risk, bank liquidity, liquidity rate, banking management, GAP JEL Classification: G21, G33 Introduction In the case of financial-banking institutions, liquidity is its ability to obtain at one point the funds needed to finance its commitments, and this should be done as soon as possible and at reasonable costs. A bank faces the need for short-term liquidity when either there is a growing demand for withdrawals from customer deposits or the loans are not reimbursed according to the maturities set with the clients and as a result the bank has to proceed to their short-term financing, which involves an additional cost to the bank. The management of the banking financial institution is responsible for providing the necessary funds to cover its short and long term obligations. Liquidity management is important in asset and liability management because Revista Română de Statistică - Supliment nr. 1 /

2 it aims at correlating the flows of funds that enter and leave the financialbanking institution so that liquidity requests - warehousing, cash withdrawals or ordered payments can be met at any time by account holders. Given the interdependence or cross-market exposure of banks, the shortcomings faced by a bank can be propagated to other players, which can trigger a domino effect and generate a systemic risk situation. To assess liquidity, banks take quantitative and qualitative factors into account. Thus, in addition to the specific quantitative and maturity characteristics, assets and liabilities must be subjectively classified (qualitative valuation) according to the liquidity level of the item. Thus, bank liquidity can be measured by a complex system of indicators that combines and weighs component elements according to their importance. Literature review Anghel and Dumitrescu (2016) analyzed the role of liquidity risk in the process of risk management within financial systems, starting from the fact that it is one of the most widespread in banking institutions. Anghelache, Anghel and Bodo (2017) addressed issues related to the importance of access to information in the decision-making process. Anghelache, Sfetcu, Bodo and Avram (2017) presented the main banking risks and their multidimensional management. Anghelache and Bodo (2016) analyzed the causes of systemic risk and how to avoid triggering a systemic crisis. Anghelache and Anghel (2014) presented key aspects of banking risk modeling. Anghelache, Dinca, Asmarandei, and Sfetcu (2009) focused on ways to predict banking risks. Blundell-Wignall, and Atkinson (2010), based on Basel III, tried to identify solutions for capital and liquidity. Crété (2012) discussed bank business activity. Delis and Kouretas (2011) have shown, through a study on euro area banks, that the low interest rate substantially increases the risk of banks. Hernández-Cánovas and Martínez-Solano (2010) investigated the link between loans and SME financing in the continental-european banking system. Ly (2015) demonstrated that the liquidity risk is negatively associated with the bank s performance by analyzing the relationship between liquidity risk, legal regulations, supervision and performance of banks in EU27 countries. Mirzaei, Moore and Liu (2013) studied the effects of market activity, banking activities and the banking environment on the profitability and stability of banks. Research methodology, data, results and discussions The notion of liquidity is the ability of a business to rapidly convert certain assets into cash (cash or available in bank accounts) with a minimum of cost in order to honor its obligations to third parties. The more liquid asset 66 Romanian Statistical Review - Supplement nr. 1 / 2018

3 is, the easier it is to convert into liquid currency (available), so the most liquid items in the balance sheet asset are the cash resources (cash and bank accounts available, and bank deposits) and the least liquid, tangible fixed assets. In this context, the lack of liquidity can be defined as the impossibility of the financial-banking institution to meet the immediate needs at a given moment with available liquidities. Given that bank liquidity refers to assets held by the bank, but also involves the management of assets and liabilities, this is a problem of asset and liability management with a different level of maturity. The situation of impossibility of payment may lead to a decrease in the confidence of depositors in the short term and, if the situation is prolonged, it can lead to a liquidity crisis for the institution. In extreme situations, as financial institutions are strongly interconnected, a bank s liquidity crisis may trigger a major (large-scale) mistrust that can trigger a significant crisis - as was the case with the onset of the economic and financial crisis worldwide in The management of a bank is responsible for shareholders to obtain the highest profits and, on the other hand, it is responsible to the authorities to ensure the stability of the respective institution. Thus, achieving an optimal balance between assets and liabilities with different maturities is a primary task for leadership, as long-term bank profitability may be affected if it has too many liquid assets (low yield, low risk). On the other hand, too few liquid assets can create significant problems, especially if they are not managed with caution. Liquidity risk can be defined as the probability of loss of financing capacity. Thus, one of the most important tasks of a bank s management is to plan the need for financing operations. Practically, the leadership of the financial-banking institution may have different practical approaches depending on the management strategy. Thus, we can consider a first approach to liquidity risk, considered classical, according to which, the liquidity risk as a discontinuity in the bank liquidity assurance process, while another, modern one, where the risk is the impossibility of ensuring in the short term the funds needed to honor the obligations that become due. Both approaches appear to be validated by practical experience, but each of them offers a different perspective of the same phenomenon. First, the classical one is based on tracking treasury transactions / funds that aim to plan and provide the required liquidity at a given time, and in view of a longer time horizon, and the second approach focuses on alternative scenarios which will ensure the immediate liquidity needs, which are used especially in the event of a crisis situation. Both approaches have the same finality, the former is considered to be the basic component that reflects the situation under stable Revista Română de Statistică - Supliment nr. 1 /

4 market conditions, and the second is the response to a discontinuity of liquidity needs due to market conditions or internal management malfunctions. The management will adopt appropriate liquidity strategies and organizational structures that will constantly pursue the need for funds and take measures to ensure that they meet the set deadline, thus fulfilling the obligation to maximize profits. Banking liquidity elements The monetary position of a financial-banking institution is the value of all its liquid assets and consists of cash in the bank, available from current accounts with other banks, reserves at the central bank, amounts receivable from other banks, payment instruments of honor. The components of the monetary position are: - Cash in the bank s cashiers both in branches and in the central treasury. The cash requirement every day is estimated based on estimates of withdrawals and collections that are established on a statistical basis. - The Central Bank or Minimum Mandatory Reserve (RMO) which each bank must hold at the Central Bank and which can be used as a liquidity valve in the event of an incident of the bank. - Available in other banks are spot deposits with correspondent banks (domestic or foreign) or interbank short-term interbank transactions. - Amounts receivable from other banks that are mainly the amounts outstanding on the interbanking circuit. Given that these elements that converge to immediate liquidity do not bring considerable income to the bank, management is interested in maintaining this position as small as possible, but maintaining the limits to ensure relative operational stability and satisfying legal requirements. Thus, the management of a bank s monetary position includes the pursuit and management of any transaction affecting the Bank s position, as well as measures to rebalance the assets and liabilities situation and, at the same time, to maximize the bank s profit by placing the available funds in profitable instruments. Cash management of a credit institution can be managed in three ways: by managing bank liabilities by reducing exposure to credit risk and collecting debts; by asset management, ie attracting new deposits or capitalizing on part of the assets; through the combined management of balance sheet assets and liabilities by continuously pursuing developments and taking corrective action from the first signs of difficulty. More modern liquidity management approaches are looking at 68 Romanian Statistical Review - Supplement nr. 1 / 2018

5 scenario analyzes that seek to identify certain vulnerabilities that might occur in the event of market shocks. Thus, after the crisis triggered in 2008, the National Bank of Romania requires market banks to periodically carry out various simulations, monitoring the bank s exposure to shocks and the level at which it is prepared to absorb some shocks, level which is the result of prudential strategies and policies implemented by the bank s management. Indicators used to assess bank liquidity The liquidity ratio represents the indebtedness (dependence) of the credit institution against the money market and is calculated as the ratio of the value of the new loans to the maturities on each maturity band and is expressed as a percentage. The values above 100% show the tendency of the credit indebtedness of the credit institution to fall on the money market and increase its own liquidity. Thus, the current liquidity rate at a given moment is determined according to the relationship: where: = current liquidity ratio; = new loans; = maturing loans. If the total of new loans exceeds that of maturing loans, we say that the liquidity ratio is positive and the bank is in a safe position without taking risks. If the value of the liabilities exceeds that of the assets at any given time, the bank is unable to meet the obligations for that term, which may lead to a decrease in depositors confidence. Given that interest earnings on loans are considerably higher than those on deposits, through this strategy and in hopes of higher incomes, the bank assumes a higher liquidity risk, requiring a very careful management of the situation. The role of management is to establish strict rules to follow in the liquidity management process, as well as to establish clear strategies that the treasury department can follow depending on the risk profile of the respective institution and the estimated profit for a certain period of time. Going forward, we can calculate the liquidity index that takes into account the evolution of liquidity over several analysis intervals, also called maturity bands, expressed in days, weeks, months, years. For each analyzed Revista Română de Statistică - Supliment nr. 1 /

6 range, a plus or minus of liquidity may result, and taking into account the weight of each maturity band in the total position, we can calculate the overall liquidity ratio as a whole, determined by: where: = liquidity ratio (on N maturity dates); = assets maturing within the i range; = liabilities maturing within the i range; = the weighting of the i range in the total portfolio. If the liquidity gap is found in one of the analysis intervals, the bank will have to take corrective measures to balance the liquid assets requirement. In addition to classical measures to attract deposits with maturity in the respective band (from depositors or from the interbank market), banks treasuries can perform transactions that offset the maturities of surpluses from other maturities to the desired maturity by maturity transformation. Maturity transformation involves the execution of specific treasury operations, which ensure the coverage of the required maturity band by collecting the maturity of some transactions. The average maturity transformation is defined as the difference between the weighted average maturity of the assets and the weighted average maturity of the liabilities. Weighing is done with the asset / pass ratio of each period and expressed in days, months, and years, best suggesting the liquidity risk that can be covered by changing the maturities that can be used. For transformation operations the relationship is used: unde: = transformation rate; = assets maturing within the i range; = liabilities maturing within the i range; = the weighting of assets in the band i; = the weighting ratio of liabilities in band i. This indicator provides a global picture of the liquidity situation in view of the degree of liquidity convertibility on various maturity bands in order to cover global liquidity. 70 Romanian Statistical Review - Supplement nr. 1 / 2018

7 Another commonly used indicator refers to the Loans / Deposits ratio, a global indicator that is computed from banks balances, and provides an overview of the coverage of loans by deposits. In analyzes, it is relevant to follow the time evolution of this indicator, which, if it shows a downward trend, can be interpreted as a positive evolution (the liquidity risk decreases - many obligations can be covered from existing deposits). Determination of this indicator is done using the formula: where: = Loan/Depozit Ratio; L = Loans; D = Deposits. Another indicator commonly used by banks is the coverage rate of the breach (GAP). This indicator is calculated as the ratio between the difference between the interest received and the payment, in relation to the difference between assets and liabilities. The indicator is expressed as a percentage and gives indications of the maximum interest that the bank can pay to secure the necessary resources if it makes a supplementary investment over the resources it already has. The calculation relationships are as follows: where: RB1 = coverage rate of the breach without operating costs and profit; RB2 = coverage rate of the breach that takes into account operating expenses and profit; CPB = that takes into account operating expenses and profit; Di = interest earned; Dp = interest paid; A - P = resource breach (GAP between Assets and Liabilities). Thus, if RB1 provides an overview of liquidity at a time, we can set RB2 by the minimum profitability threshold to attract additional funds for the needs at a given time. Revista Română de Statistică - Supliment nr. 1 /

8 Conclusion Currently, liquidity risk management has become a bank asset management activity, which is based on a clear strategy set by shareholders and the assumption of a related risk profile. The management of the bank is responsible for the implementation of this strategy and, on the other hand, to ensure the prudential framework imposed by the NBR for measuring, monitoring and controlling the liquidity risk by which banks are obliged to take into account the strategy, methods and liquidity management, maximizing profit. A bank must have a liquidity management structure to implement its liquidity strategy, programs and procedures, usually managed by the ALCO (Assets and Liabilities Committee). Banks must designate at the highest level of management the responsibility to establish the liquidity program and review their liquidity decisions. Another particularly important aspect of liquidity management in times of crisis is the analysis to determine financing needs in the future. Banks need to analyze liquidity needs in the future, both for short and longer periods, and also to establish various scenarios of solutions in crisis situations. In the end, the leadership of each bank must be concerned that preventing it is preferable to repair. Permanent liquidity assurance is an important objective in each bank s strategy, as it provides added value to the bank s image and safety, and customer confidence is a mirror of the reputation and profitability of the bank. References 1. Anghel, M.G. and Dumitrescu, D. (2016). Model for Analyzing the Liquidity Risk, Romanian Statistical Review Supplement, 6, Anghelache, C., Anghel, M.G. and Bodo, G. (2017). Theoretical aspects of the role of information in the process of decisions/risks modeling. Romanian Statistical Review, Supplement, 6, Anghelache, C., Sfetcu, M., Bodo, G. and Avram, D. (2017). Theoretical notions about bank risks. Romanian Statistical Review, Supplement, 11, Anghelache, C. and Bodo, G. (2016). Theoretical aspects regarding systemic risk and managerial decisions during the crisis. Romanian Statistical Review, Supplement, 12, Anghelache, C. and Anghel, M.G. (2014). Modelare economică. Concepte, teorie şi studii ce caz, Editura Economică, Bucureşti 6. Anghelache, C., Dincă, I., Asmarandei, A. and Sfetcu, M. (2009). Principalele măsuri de prevenire a riscurilor bancare. Romanian Statistical Review, Supplement, 6, Blundell-Wignall, A. and Atkinson, P. (2010). Thinking beyond Basel III. Necessary Solutions for Capital and Liquidity. OECD Journal: Financial Market Trends, 2 (1), Romanian Statistical Review - Supplement nr. 1 / 2018

9 8. Crété, E. (2012). Analysis of banking activity by business line. Quarterly selection of articles - bulletin de la Banque de France, 26, Summer, Delis, M. and Kouretas, G. (2011). Interest rates and bank risk-taking. Journal of Banking & Finance, 35 (4), Hernández-Cánovas, G. and Martínez-Solano, P. (2010). Relationship lending and SME financing in the continental European bank-based system. Small Business Economics, 34 (4), Ly, K.C. (2015). Liquidity Risk, Regulation and Bank Performance: Evidence from European Banks. Global Economy and Finance Journal, 8 (1), Mirzaei, A., Moore, T. and Liu, G. (2013). Does market structure matter on banks profitability and stability? Emerging vs. advanced economies. Journal of Banking & Finance, 37 (8), Revista Română de Statistică - Supliment nr. 1 /