Why is managing banks’ liquidity risks so important?

Liquidity is the ease with which an asset can be converted into cash without affecting its market price. Liquidity risk is one of the most significant risks that banks need to manage appropriately to avoid failure. It is a sudden surge in liability withdrawals that may leave banks in a position of having to liquidate assets at a very short notice and low prices. Banks collect deposits on short-term bases and lend the money on long-term bases, which create a gap between the terms of deposits and loans. The deposits mature earlier than the loans usually do. As a result, banks have to arrange liquid assets from other sources to meet the liability withdrawals. When they fail to collect such assets, they face liquidity risk.

There are three liquidity management strategies that banks usually employ. The first is asset liquidity management or asset conversion strategy, which calls for piling up liquidity in the form of liquid assets and selling them when needed. Banks generally hold some assets that they can sell when they face such a problem. Although this strategy minimises the liquidity risk, it reduces the profitability as well, because maintaining more liquid assets generate less return.

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Issues our banking sector must address

The second strategy is borrowed liquidity or liability management strategy. This allows banks to borrow from the market to cover all of its liquidity needs. This is a risky strategy because borrowing from the market may be highly expensive during a liquidity crisis. Sometimes, borrowing may also not be possible due to the unavailability of funds.

The third is a balanced liquidity strategy, which combines the use of liquid asset holdings and borrowed liquidity to meet liquidity needs. Here, a bank not only holds some liquid assets, but also makes contracts with other banks for borrowing at the time they need money. It also takes a standing borrowing facility from peers having excess liquid assets.

Liquidity managers should follow some guidelines to avoid liquidity problems. Generally, they have to keep track of all fund-using and fund-raising departments; they must know in advance about withdrawals by the biggest credit or deposit customers. Furthermore, priorities and objectives for liquidity management should be clear. A bank, for instance, may try to manage liquidity in a way that it will never face a liquidity crisis. Finally, liquidity needs must be evaluated continuously—daily, weekly, monthly, quarterly, and yearly.

Banks have to estimate the amount of liquidity needs, which they can do using four approaches. The first is sources and uses of funds approach, where loans and deposits are forecast for a given liquidity planning period. Here, the probable change in loans and deposits are also calculated. Then the liquidity manager estimates the bank's net liquid funds by making a comparison between the estimated changes in loans and deposits.

The second approach is the structure of funds approach, where a bank's deposits and other funds are divided into categories such as volatile, vulnerable, and stable funds. The liquidity manager sets aside liquid funds in accordance with some operational rules. A bank may keep, for instance, 85 percent of volatile funds always ready for withdrawal. This percentage is determined by previous experience and expected change in the customers' financial behaviour.

In the third approach, known as the liquidity indicator approach, a bank calculates different ratios which are compared with some benchmark to understand its liquidity position. If some ratios like cash position, liquid assets, volatile funds, core deposits and deposit composition of a bank reach the benchmark, the bank is said to have maintained the required liquidity position.

The fourth approach uses signals from the market to assess liquidity needs. Hence, liquidity managers closely monitor the signals such as public confidence, stock price behaviour, risk premiums on borrowings, loss sales of assets, and borrowings from the central bank. The public confidence in a bank will be low if it does not have top-notch liquidity management. A bank that offers high interest rates on borrowing or receives liquidity support from the central bank frequently gives a signal that its liquidity management is not effective, and the risk is high.

When a bank has a liquidity crisis, it tries to borrow from other solvent banks to pay its depositors. If the solvent banks do not extend this support, the bank's liquidity crisis aggravates, resulting in a panic among its customers. The panicked customers hurry to withdraw their deposits, which may push the bank into an acute liquidity crisis. This way, a sound bank can become insolvent, failing to meet the liquidity needs.

Global experience shows that during the 2008 financial crisis, the biggest bank failure in the US history occurred with the closure of Washington Mutual, which had $307 billion in assets. A run on deposits where its customers withdrew $16.7 billion in just two weeks was one of the reasons why this bank failed.

Dexia, a Franco-Belgian bank, had high maturity mismatch as it heavily borrowed short-term funding to make long-term loans. It expanded its balance sheet from 258 billion euros in 2000 to 651 billion euros in 2008, before collapsing after a liquidity crisis in October 2008. Then Dexia faced a second liquidity crisis in 2011 from which France, Belgium and Luxembourg rescued it to avoid bankruptcy, costing taxpayers over 18 billion euros.

Merrill Lynch was an investment bank in the US and existed independently until January 2009. Its residential mortgage loans rose to $100 billion in 2007, from $58 billion in 2005. The mortgage assets went under pressure and Merrill Lynch was forced to reduce its risk by selling assets at a loss. The bank faced a record loss of $37.9 billion in 2008, resulting in liquidity shock. Later, it was acquired by the Bank of America in January 2009.

In 2023, the US saw the failure of Citizens Bank in November, Heartland Tri-State Bank in July, First Republic Bank in May, and Signature Bank and Silicon Valley Bank in March. Before collapsing, customers of Silicon Valley Bank had withdrawn $42 billion in just 48 hours.

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Implications of recent central bank policy measures

Banks in Bangladesh sometimes face liquidity crises from normal operational outcomes. However, several banks have been encountering liquidity problems for a long period of time, mainly because of irregularities arising from a lack of good governance. The irregularities gave birth to huge amounts of non-performing loans (NPLs) where funds remained blocked. BASIC Bank with a default rate of 63 percent, Padma Bank with 46 percent, and Bangladesh Development Bank Ltd with 42 percent found their liquidity risk management simply unrealistic. The Bangladesh Bank had to provide special support to some Islamic banks to help them overcome their liquidity problems, which originated allegedly from unlawful activities.

Without ensuring good governance in the banking sector, liquidity management strategies will not function properly in Bangladesh's banks. A standard setting must be created for suitable liquidity management practices. If not, liquidity risk can make many banks extremely vulnerable, needing them to be rescued at the expense of taxpayers' money.

Dr Md Main Uddin is professor and former chairman of the Department of Banking and Insurance at the University of Dhaka. He can be reached at mainuddin@du.ac.bd.

Views expressed in this article are the authors' own.

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