Management rules in a bank. Liquidity risk
Category: Bank Management
Different kinds of risks
Just like any company, credit institutions have to face many constraints; because of their type of activity and their economic role, three main constraints can influence their strategy.
First, credit institutions depend on the Monetary policy, on the evolution of the financial situation of their customers which is linked directly to the budget policy.
Secondly, Public Authorities decide upon Banking regulations because of the role banks play in the Economy; these regulations are necessary and banks have to respect them.
Thirdly, the banking business gives birth to Management constraints different from those of a non-banking company.
In this Module, we will describe the main Management Rules to face these specific constraints, directly linked to the risks: it is the management of the main banking risks: liquidity, interest rate, exchange rate, counterparty risks.
We will now study the ways of measuring the different risks and the methods to limit their effects; the importance of these risks is underlined by a strict prudential regulation.
Liquidity risk
Definition
Like any juridical entity, a credit institution has to fulfil its obligations at any time; so, it must be able to face the withdrawals of its customers whatever the amount. If not, there is a liquidity risk.
To avoid this situation, a credit institution must keep a significant part of its assets available in the short term, so as to get them back to face withdrawals of customers.
So to keep their assets liquid banks try not to immobilise too much capital.
The origin of the risk comes from a gap between the duration of the resources due (to be paid) and that of the loans (longer as an average).
If this bank has a confirmed credit line granted by a financial institution up to 60, it will face a liquidity risk on month 10 to face its reimbursements.
The current accounts should be classified in the shortest duration column, in fact, a good part of these deposits can remain in the bank’ s vaults.
Liquidity risk can also come from a lack of confidence from depositors, in the Bank; this can be due to information about bad financial results due to bad debts. In that case, the bank might have to face:
— massive withdrawals from depositors
— cancelling of Interbank credit lines
Managing the liquidity risk
The changing of the duration between resources and loans is the normal activity of a bank: so this risk has to be managed carefully. Two methods can be applied:
The bank must try to correct the excessive maturities; for instance, it can pay more interest on long term deposits or set up limits on such or such assets. The results of this method can be measured in the long run.
The bank must benefit from sufficient credit lines thanks to a permanent access to the different markets (interbank, monetary, financial); another problem is the cost of this refinancing.