- A bad bank anywhere is a threat to banks everywhere — thanks to globalisation
Pat Thomas, one of my favourite Ghanaian musicians is credited to have sung that “money is blood”. He could not have said it any better. Years later, Daddy Lumba, another master lyricist also waxed philosophically that “although money does not give life per se, it does promote life and the quality thereof”.
The latter musician states humuorously that “if one does not have blood in their physical body, one does not have life; that while money is not blood itself, it is used to purchase blood tonic that promotes life”. As a teenager, I used to think, rather naively, that plump people necessarily have more blood in their system than others not so endowed.
A lot has been said and sung about money and liquidity. In the field of banking, it is the form that money takes and its availability and adequacy that are critical to the survival of the banking organization.
In my introductory years in the study of accounting in the 1970s, I used to be so fascinated about the T/ Accounts and the double entry system of accounting. Preparing these to the point of the Trial Balance and ultimately the Balance Sheet produced such a sense of accomplishment for me before and during examinations. Now computerization has taken the fun out of complete and incomplete accounts preparation.
Then came introductory balance sheet analysis. The norm was to emphasise ratio computations and trend analysis, especially the current and acid test ratios that were considered to be the best metrics for determining how solvent a firm was.
A current ratio of 2: 1 was the benchmark for most businesses until at the GCE Advance level stage, we were taught to be more analytical in considering that the nature of the firm and even the business cycle peculiar to the firm and industry were crucial in determining its solvency. Different firms or industry players exhibit peculiar characteristics as far as this basic ratio is concerned.
A typical supermarket with a multiplicity of debtors and creditors is to be distinguished from a steel manufacturing firm surviving on long term debt instruments in most cases. A poultry firm may similarly exhibit different levels of liquidity or working capital from the stages of hatching, feeding, egg laying to dressing of the birds for consumption.
Generally, the number of times current assets exceed current liabilities is a valuable measure of a commercial firm’s solvency. A rule of thumb places a strong current ratio at two, meaning that the current assets must cover the current liabilities by at least two times.
Most importantly this metric has little relevance in banking in view of the uniqueness of this business unit from other commercial entities. Whereas, most entities prepare their balance sheets, beginning with Fixed Assets, less depreciation, before considering Current Assets, bank balance sheets preparation curiously begins with Current Assets and end with Fixed Assets and how these are financed by equity, debt, permissible reserves and other funding sources approved by the Regulator.
In view of the critical role banks play in the financial intermediation maze, bank capital, liquidity and their components are intensely regulated by central banks and reinforced by Basel 111 requirements. The emphasis placed on liquidity management is central to the analysis of the solvency of a typical bank.
Variations may occur in respect of the predominance of the bank’s operations in the commercial/retail arena or development or corporate banking bias of the bank concerned. The Regulator reserves the right to determine the level of capital and liquidity commensurate with the risk profile of a licensed bank.
The Bank for International Settlements states that “the formality and sophistication of the processes used to manage liquidity depends on the size, sophistication of the bank as well as the nature and complexity of its activities. (Sound Practices ForManaging Liquidity in Banking Organisations, Feb. 2000)
In particular what constitutes Current Assets and Current Liabilities have significant peculiarities in the banking domain. This will be explained subsequently.
The place of liquidity management is highly crucial to the survival of a bank, hence the critical role of the Assets and Liability Management Committee (ALCO) of the individual bank and their place in the strategic and routine management of the bank as far as the sources and application of banks’ funds are concerned.
A quick caveat must be posted here to the effect that the pieces of articles that follow do not seek to explain the link between bank liquidity and profitability and the place of risk appetite determination for a bank board of directors.
The primary focus here is to examine what constitutes bank liquidity; how this differs from liquidity as expressed in other trading or commercial entities, the likely causes of bank illiquidity and how to deal with liquidity crises when they emerge.
The strategic link between capital, liquidity and profitability and how this affects the maintenance of an optimal balance in the risk space will be explored in later articles.
In local Akan parlance, it is said that the real hunter is the one who currently has bush meat being smoked in his fire hearth. Buyers of meat are least interested in who touts himself as a prolific hunter. Instead, such buyers would naturally gravitate towards the hunter with a sack full of their needs or a hearth amply stocked with a variety of bush meat readily available for consumption immediately. At the time this need must be satisfied, no one is amused by the hunting prowess of the hunter but the availability of edible meat stock at hand.
Similarly, in banking, magnificent head offices and imposing branches, fleet of vehicles, reputation or goodwill may be assets, but only to the extent that the bank is able to apply these to meet its recurring liquidity needs without impairing its profitability and ultimate solvency. The Regulatory requirement to maintain a mandatory ratio between Earning and Non- Earning Assets is premised on this absolute requirement for liquidity at all times.
Bank liquidity risk explained
Bank liquidity risk can be defined as the potential inability of a bank to meet its financial obligations as they become due. This may be viewed either under the going concern conditions or during an extreme event. Liquidation risk can thus be considered to be the potential loss occasioned by the forced sale of an asset resulting in proceeds being below fair market value, like being pressured to sell off a subsidiary or other vital asset to meet crunching liquidity needs.
Liquidity is of utmost importance; some say, it is the life blood of banks. It is not the absolute funds /money held (liabilities) or even profits per se that take prominence, but the form those monies or funds take and their availability and adequacy relative to time. This is critical to the survival of the banking firm that must meet routine and even extreme or unforeseen obligations, lest a run on the bank could lead to its collapse.
In its simplest form, therefore, liquidity relates to the ease with which the bank can get access to cash or turn investments into cash without losing substantial value as they meet contractual customer obligations.
Banks thrive on liquidity to the extent that there must always be adequate cash funds to meet clients’ withdrawals- whether these are original depositors or customers who have been given loans and overdraft facilities or when other contingent obligations fall due.
Liquidity risk may impair the bank’s ability to generate cash or cash equivalents to cope with declining deposits, a strategic decision to increase fixed assets, eg technological enhancement or the expansion of the loan portfolio to take advantage of emerging opportunities.
The concept of liquidity dates back to the origins of banking when medieval bankers realized that at any point in time not all the depositors of cash and other valuables came for them at the same time. Even in the absence of complex probability theories then, it was evident that the early bankers could safely lend a part of their deposit holdings to others who required funds for their operations, for a defined time while they earn some decent interest in the process.
This idea birthed the modern-day reserving requirements of banks, depending on whether these banks operate in jurisdictions with a deposit protection insurance scheme, or the central bank requires them to keep specific proportions of their deposits in cash and cash equivalents as primary and secondary reserves.
The emphasis placed on liquidity management in the current Basel 111 arrangements exemplify the importance of the basic principle of liquidity and its management to the survival and profitability of banking organisations. These requirements have been designed to stem banking crises and their deleterious effects on global financial systems over the last three decades.
In the banking space, financial obligations or outflows include meeting deposit liabilities. Assets include loans and advances, fixed assets in the form of buildings, plant and equipment. Other outflows include operating expenses and off-balance sheet facilities which may eventually crystallize, without adequate provisions. It is important to underscore the challenges faced by banks’ executives, particularly those charged with the management of the Assets and Liabilities.
For outsiders, a glance at the published financials in aggregate form (which is a snapshot at a point in time) may give some comfort regarding the ability of the bank to meet obligations falling due. For the members of the ALCO and other astute analysts, however, further information regarding the mix and tenor of both assets and liabilities may depict a scary position.
It is not unusual to find a bank operating on a mismatch basis, where the quantum and mix of assets and liabilities may differ from a strategically defined threshold, in line with its risk appetite and firm mechanisms outlined in its Liquidity Contingency Plan (the concept and modalities of which will be explained in the next article).
However, it is level of mismatch or liquidity gap that determines the strength of the balance sheet and the board’s capacity to meet its strategic objectives. This may not be so apparent to a casual observer of the financials. Banks engage in what is called maturity transformation. This means lending for longer periods than those from which they borrow. While the bank’s lenders (the depositors), have a preference for short term maturities, the bank’s borrowers require longer term funding.
The degree of mismatch and the capacity to absorb inherent shocks, determines the strength of the balance sheet. The size and sophistication of the individual bank and its risk profile, particularly the sectors it plays in predominantly, are key issues that influence the gap analysis depicted in the liquidity ladder. This may not be so apparent to a casual observer of the financials.
Ordinarily, every bank wants to deploy maximum funds in advances and medium term, relatively high yielding investments through loans and advances, bonds and similar instruments. This objective would, however, be constrained by the nature of the deposits held, particularly their tenor and holder concentration characteristics.
The higher the level of demand deposits, the less the bank’s ability to lend for longer terms. This structure may, however, be compensated by relatively lower aggregate cost of funds. It is a major characteristic of Ghanaian banking that funds in the ambiguous maturity spectrum (short term current accounts, savings, notice deposits) predominate the deposit structure of banks’ balance sheets. To a large extent, this reflects expectations of future interest and exchange rates movements and or business confidence in the medium to long term horizon.
Ambiguous maturity liabilities are known to exhibit behaviour that differs considerably from the contractual product definition, especially in a volatile interest rate regime. A new government policy that is perceived to be inimical to the interests of this class of depositors creates volatility in the level of liquidity.
This is perhaps the biggest impediment to the granting of long-term loans and advances by the banks, among other factors.
For any individual bank, unbridled mis-matching, often caused by high risk appetite, can lead to endemic liquidity crisis which may end up with high interest payments and potential reputational problems from an inability to meet pressing financial obligations.
A strong relationship exists between market and credit risk which must be addressed holistically in liquidity management. In a highly volatile interest rate regime, loan default rates increase. This can affect the quality of the loan portfolio and expected cash flows. The quality of the loan portfolio obviously affects credit risk. The principles of effective selection, limitation and diversification are essential in managing the credit portfolio and its effect on the bank’s liquidity management.
To ensure sanity and prevent systemic risks, however, the central bank ensures that banks keep enough liquid resources commensurate with their deposit liabilities and other exposures. The regulator may permit temporary imbalances with firm and credible commitments by the non-compliant bank to revert to normalcy within clearly defined time frames. For instance, a key effect of the covid 19 pandemic was a reluctance of banks to expand credit with the effect of lowering production of goods and services.
The Regulator’s reduction of the reserving requirement of the universal banks was aimed at stimulating credit expansion to avert declining economic growth. The measure included prescribed volumes or proportions of cash and cash equivalents like easily marketable securities in both local and foreign currencies that must be held by the banks.
The individual bank’s management must also ensure that it operates within clearly defined internal guidelines in line with the requirements of its Assets and Liability Management policy and risk appetite levels.
Residual liquidity challenges remain inherent to be managed in view of the structure of both sides of the balance sheet. Typical ambiguous maturity liability products (as they are called) are Call deposits, Savings deposits, Current accounts, Notice deposits, and Customers’ Foreign Currency deposits. The liabilities portfolio may also harbor inherent risk due to its composition in relation to the maturity profile, diversity of depositors, interest and exchange rate dynamics.
During a liquidity crisis, these products manifest a high attrition rate of the liability base, calling for measures to mitigate any attendant risks. A Liquidity Contingency Plan must profile these liabilities with decidedly conservative behavioural assumptions to avoid surprises.
To increase the likelihood of surviving a liquidity crisis, lower the associated costs involved, potential regulatory sanctions, and reputational backlash, it is imperative to identify liquidity problems early.
Published financials of banks and other entities tend to portray a comforting appearance of the financial health of the organization, without further probing into concentration dynamics which may mask liquidity challenges.
As a rule of thumb, liquidity challenges may arise from:
- The need to replace outflows of deposits due to withdrawal of retail deposits or non-renewal of fixed deposits, particularly by key customers, like the Telcos.
- The need to compensate for non-receipt of expected inflow of funds, where systemic crises have led to poor loan repayment,
- The need to source fresh funding to meet contingent liabilities that have crystallized
- The need to take advantage of new short- term opportunities in the market.
The next article will examine in depth the potential causes of a liquidity crises, the role of the Assets and Liability Committee of a typical bank; what informs their decisions and the usual strategies and methods adopted in dealing with liquidity challenges.
- Risk Management in Banking, CIB Publication, authored by Francis Owusu-Achampong,FCIB. 2018
- Sound Practices For Managing Liquidity in Banking Organisations, BCBS, Feb. 2000
- Risk Management, Indian Institute of Banking and Finance, 2010
- Asset and Liability Management- An Overview, Oracle Corporation, 2008.
The writer is a Fellow of the Chartered Institute of Bankers and an adjunct lecturer at the National Banking College, a farmer, and the author of “Risk Management in Banking” textbook. Email; [email protected] Tel. 0244 324181