What are the tools and strategies banks use to manage liquidity effectively?

Liquidity is the ability of a bank to meet its financial obligations and customer demands without incurring excessive costs or risks. Liquidity management is a crucial function of banking, as it ensures the smooth functioning of the payment system, the stability of the financial system, and the profitability of the bank. In this article, you will learn about the tools and strategies banks use to manage liquidity effectively.

1 Liquidity sources and needs

Banks have various sources and needs of liquidity, which depend on their business models, market conditions, and regulatory requirements. Some of the common sources of liquidity are customer deposits, interbank loans, money market instruments, central bank facilities, and asset sales. Some of the common needs of liquidity are customer withdrawals, loan disbursements, debt repayments, margin calls, and reserve requirements. Banks need to balance their sources and needs of liquidity to avoid liquidity shortages or surpluses.

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Birendra Sahu, FRM, CISI

Principal Business Analyst, Product, Platform and Technology
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In my experience, one should also consider the stickiness of the sources of liquidity. e.g. within customer deposits, savings and current account deposits are stickier than the term deposits. Stickiness indicates how likely deposits will be renewed upon maturity including under conditions of stress and help the bank decide additional liquidity requirement.

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Viswanathan Venkatasubramanian, FRM
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An essential aspect for banks is to analyze their liquidity in terms of core versus non-core components and to monitor shifts between assets and liabilities regimes. This approach enables banks to differentiate between stable and reliable sources of liquidity (core) and those that are more volatile and unpredictable (non-core). By categorizing liquidity in this manner, banks can make more informed decisions regarding their funding sources and needs. Additionally, monitoring shifts in liquidity regimes allows banks to adapt their liquidity management strategies proactively, ensuring a balanced and resilient liquidity position

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2 Liquidity ratios and indicators

Banks use various liquidity ratios and indicators to measure and monitor their liquidity position and risk. Some of the widely used liquidity ratios are the liquidity coverage ratio (LCR), which compares the high-quality liquid assets (HQLA) to the net cash outflows over a 30-day stress scenario; the net stable funding ratio (NSFR), which compares the available stable funding (ASF) to the required stable funding (RSF) over a one-year horizon; and the loan-to-deposit ratio (LTD), which compares the total loans to the total deposits. Some of the common liquidity indicators are the cash flow gap, which shows the difference between the expected inflows and outflows of cash over various time buckets; the liquidity buffer, which shows the amount of HQLA that can be used to cover unexpected cash outflows; and the liquidity cost, which shows the opportunity cost of holding HQLA.

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Viswanathan Venkatasubramanian, FRM
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Main thing which a bank needs to understand here is that mismatch between cash flows by looking at the various indicators such as LCR and NSFR. This adds valuable insights to what a bank can withstand during adverse market conditions.

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3 Liquidity policies and procedures

Banks need to have clear and comprehensive liquidity policies and procedures to ensure effective liquidity management. These policies and procedures should define the roles and responsibilities of the liquidity management function, the liquidity risk appetite and limits, the liquidity contingency plan, the liquidity reporting and disclosure, and the liquidity stress testing and scenario analysis. The liquidity policies and procedures should also be aligned with the regulatory standards and best practices, and be reviewed and updated regularly.

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4 Liquidity tools and strategies

Banks use various tools and strategies to manage their liquidity effectively, such as asset-liability management (ALM) to match the maturity and interest rate profiles of assets and liabilities, diversification of funding sources to access different markets, instruments, currencies, and counterparties, liquidity transfer pricing (LTP) to allocate costs and benefits of liquidity, liquidity optimization to maximize return on HQLA and minimize cost of funding, and liquidity hedging to hedge exposure to liquidity and interest rate risks using financial instruments.

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5 Liquidity challenges and opportunities

Banks face various challenges and opportunities in managing their liquidity effectively. Common challenges include market volatility and uncertainty, competition and innovation in the banking sector, and regulation and supervision of the banking sector. Opportunities for banks include digitalization and automation of banking processes, collaboration and integration of the banking sector, and education and awareness of banking stakeholders. Digitalization can improve efficiency and accuracy of liquidity measurement and monitoring, while collaboration can enhance access to funding markets and instruments. Education can increase understanding of the importance of liquidity management, as well as liquidity risk appetite and limits.

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Viswanathan Venkatasubramanian, FRM
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Efficacy of a bank can be measured and improved by adopting a very robust IT systems integrating all the desks at one place. Thereby Senior management people can view the ratios and act accordingly.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What are the tools and strategies banks use to manage liquidity effectively?

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1 Liquidity sources and needs

2 Liquidity ratios and indicators

3 Liquidity policies and procedures

4 Liquidity tools and strategies

5 Liquidity challenges and opportunities

6 Here’s what else to consider

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