Potential causes of a bank liquidity crisis
Liquidity crises may originate from a variety of sources, including internal and external fronts. Just as a rainbow may draw attention to impending rains, a liquidity crisis usually precedes a bank collapse, if not managed effectively. Some of the collapsed indigenous Ghanaian banks manifested this scourge, leading to the infusion of Extended Liquidity Assistance scheme from the Regulator, which was unfortunately dissipated in wrong investments and blatantly unethical practices.
Low or tight liquidity is when cash is tied up in non-liquid assets or a bank’s liquidity has been severely impaired by rising non-performing loans when the cycle of cash flows is dented by massive defaults in loans previously granted.
Low liquidity may also arise from unbridled acquisition of fixed assets without dedicated funds for such purposes, like the former Beige Bank investing in multiple property purchases. Such tendencies are proscribed by the Banks and Specialised Deposit Institutions Act 930.
Liquidity risk management is therefore crucial to the profitability and survival of a bank. The Regulator employs various stress tests to evaluate the preparedness of the bank to meet routine operations and hold a buffer for emergencies.
A variety of measures are available to the central bank to ensure that adequate liquidity cushions are available in each bank. Currently the main vehicle is the maintenance of reserving ratios, broken into primary reserves that are usually held in cash balances held with the central bank or other universal banks and approved marketable assets like treasury bills, bonds and other short- term instruments.
As a normal rule, banks engage in 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.
Ordinarily, every bank wants to deploy maximum funds in advances and medium term, relatively high yielding investments. This objective would, however, be constrained by the nature of the deposits held.
The higher the level of demand deposits, the less the bank’s ability to lend for longer terms, although this structure is usually compensated by relatively lower aggregate cost of funds. It is a major characteristic of Ghanaian banking. Unbridled mis-matching can lead to endemic liquidity crisis which may end up with high interest payments and potential reputational problems from inability to meet pressing financial obligations.
Broadly, a liquidity crisis may originate from two broad areas; these are bank specific (internal) factors and systemic or industry wide (external) events.
Internal (bank-specific) factors
Negative publicity about a particular bank and its ability to meet routine customer withdrawals may lead to a liquidity crisis. This could even be compounded by withdrawals made by key customers, hence the constant monitoring of the Top 20 Depositors to identify movements in this quadrant of the depositor concentration mix.
Liquidity problems may arise from a loss of confidence in a specific bank. Bank deposits are typically confidence-sensitive with potential to trigger large scale withdrawals. Panic driven withdrawal of deposits (‘run on the bank’) could have adverse liquidity implications. This could even be worsened if such uncertainties are combined with massive draw-downs under loan commitments, as customers fear that credit will dry up.
Weak liquidity management arising from a failure to properly forecast imminent financial obligations or laddering of the various assets and liabilities may precipitate a liquidity crisis. This may arise from poor monitoring of the bank’s positions in the various assets and liabilities classes and also the various currencies it is exposed to.
Off-balance sheet exposures can also be a serious source of illiquidity for a bank. The $ 68 million legal exposure of National Investment Bank Ltd, which the Supreme Court overturned could have been a game changer if the bank had lost the case as it did in the lower courts.
Contingent liabilities that are not properly provided for or anticipated can derail the bank’s liquidity, hence the recommended treatment of IFRS 9 and the emphasis on disclosure requirements, per the Basel 11 accord.
Perhaps even more crucial is a major credit risk event. A typical scenario is what some of the major banks suffered in the case of the Finatrade loan losses and generally the loan write-offs occasioned by the combined effects of the energy companies’ indebtedness to some banks.
Although this particular event manifested a tinge of a systemic risk in view of the variety of banks that were affected, the extent of each bank’s exposure depended on its capital and other exposures in the sectors in which it predominates.
Regulatory write-down of the loan portfolio following inspection/audit by the Regulator could have similar liquidity effects. The GCB Bank PLC’s massive write-downs of the Tema Oil Refinery debt situation in 2011 was a typical example.
Other major defaults or rise in non-performing loans portfolio resulting in a material financial loss could also trigger a liquidity crunch. This may manifest strongly in the collapse or default of a Top 20 Borrower of any specific bank.
Conversely, unanticipated withdrawals made by a Top 10 Depositor like a telecommunication company which usually holds large deposit balances could derail the liquidity position of a bank.
Market risk events causing abrupt changes in interest or exchange rates that negatively impact the bank’s open positions may affect a bank’s liquidity position.
An operational risk event like major losses resulting from regulatory fines or court damages could trigger a liquidity problem, like the $11 million loss Standard Chartered Bank Gh. Ltd suffered in what may be considered mundane transactions involving wrongfully returned cheques. Similarly, a compliance risk event like heavy fines from other regulatory bodies for identified breaches of law could dent a bank’s liquidity, just as a reputational risk event.
A major scandal or public perception of a bank’s potential failure, especially the immediacy, severity and duration of the crisis would be highly correlated to the bank’s previous history of similar events and consequently dents its liquidity
Systemic liquidity crisis (external factors)
From the external perspective, a liquidity crisis could stem from contagion by association, eg failure in the non-bank financial segment to which a bank is exposed. In a volatile environment, the possibility of this risk precipitating is indeed heightened, especially following the demise of some indigenous Ghanaian banks and other non-bank financial institutions, eg Savings and Loans/Pyramid schemes.
Panic created by uncertainties regarding the proposed introduction of the e-levy could also trigger mass withdrawals from mobile money wallets of the Telcos, and by extension, bank deposits. Such panic may be exacerbated by pedestrian, ill- informed media discussions on government intentions regarding customer mobile money wallets.
Another major cause of a liquidity crisis may be a payment system disruption, eg. systemic failure of the Clearing system since banks are closely interconnected. Illiquidity can stem from gridlocks in the infrastructure of the payment, clearing and settlement mechanisms that, in turn, reduce liquidity in financial markets. The problem may be short-term and can be minor or severe, depending on how it is handled.
A disruption in the capital market – the stock exchange and allied institutions may also cause a systemic liquidity crisis as banks are key participants in the intermediation processes. Typically, such events would be associated with a “flight to quality” destinations when there is a perception of local financial or industrial tremors. Prior to 2006, the United States financial system became the key beneficiary of excess liquidity from rising oil revenues of the oil exporting countries, especially the Nordic countries.
During the crises that spanned that period until about 2008, the same market suffered a liquidity crunch as investors looked for safe havens for their investments. Capital flight is a normal experience in free market economies, and banks are usually the key losers of out- bound capital.
The current depreciation of the cedi,coupled with the not so exciting short term performance on the Ghanaian stock exchange,could also precipitate cedi illiquidity as investors and speculators alike engage in selling cedi for foreign exchange as a hedge against further depreciation and interest and exchange rate volatilities.
Macro-economic crisis (credit crunch or asset price bubble) could also be a source of liquidity crisis. A credit crunch is typically associated with banks not willing to further extend credit to qualifying borrowers. This would, in turn impact the ability of these borrowers to service their debt.
An overheated economy can lead to unsustainably high asset prices, such as in the equities or property markets, resulting in a major correction or crash. The Ghanaian real estate sector with their comparably over- priced property values is an area worth watching in the credit expansion arena.
Big or small banks are both susceptible to liquidity crunches and ultimate failures. This may arise from over ambitious expansion schemes, over-trading, manifested in low prudential ratios and panic sale of marketable securities. Panic induced borrowing at off-market rates for an extended period, concentrated and volatile deposits, as well as spikes in non-performing loans may similarly pre-dispose a bank to liquidity crisis.
Analysts must bear in mind, though, that the health of banks cannot be gleaned solely from the financials and even accompanying disclosures now forced by regulation.
Risk management practitioners must appreciate that the figures so presented in the balance sheet, may mask the true state of the risk of the bank under consideration. Financials usually involve a huge dose of estimation and subjective judgment regarding the values of key items like Loans and Advances, the related Non- Performing Loans provision, Goodwill, and Fixed Assets (minus depreciation) in the income statement and balance sheet of different banks.
Functions of the ALCO
Obviously, different banks would adopt different approaches to liquidity management due to their individual sizes, market share, sector concentrations, geographical spread, major liability sources and profile of assets and risk appetite.
A bank specific stressed liquidity situation requires a centralised effort in order for decisions to be clear, decisive and elicit prompt responses. Depending on the size and complexity of its operations, a bank may establish a Liquidity Crisis Management Team (‘LCMT’) or in most cases, the existing Asset and Liability Management Committee will determine the probability, severity and estimated duration of a liquidity crisis, and devise appropriate remediation.
This team must have a broad-based authority vested in it by the board. Its key task must be to define and implement the liquidity strategy to deal with the crisis, having identified the remote and immediate causes from periodic reports made available to them.
In dealing with a liquidity crisis, prominent issues that need to be dealt with include the Bank’s communication strategy to identified stakeholders, the availability and use of the different sources of liquidity, how the local money market perceives the bank’s degree of liquidity, resort to the Central Bank as lender of last resort; the nature of people and system support together with the logistics of cash management over large networks.
Assets and liability management is described as a continuous process of planning, organizing and controlling the assets and liability volumes, maturities, rates and yields of various instruments the bank deals in. The function may also be described as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates.
The loan portfolio as depicted in the balance sheets of two banks, for example, may differ significantly due to their inherent risk factors, especially regarding the age, sectoral or recoverability profile in the different banks. These factors impinge heavily on the liquidity profile of the individual banks.
Similarly, where the liability portfolio is held by a few depositors who draw their revenues from oil and gas related fields, for example, their collective draw downs on these deposits could have significant adverse impact on the bank’s liquidity. This may occur especially where loans of a certain maturity profile had been granted. The risks associated with these simple examples are classified as concentration and mismatch risks, respectively.
It is also important to underscore the fact (often less understood), that profit is an opinion that is derived from accounting conventions and principles while cash flow is a fact. Methods of valuing assets, assessing liabilities, or provisioning for losses are at the discretion of the board and management. Their ideas on these may not be static, though consistency in the application of these concepts is a cardinal accounting principle.
Thus, a bank could be making profits but still have challenges with short term liquidity. For instance, Excellence Bank Ghana PLC may have had an opportunity to finance a ship-load of refined oil for the Volta River Authority against very fine margins and after a dispensation from the Regulator over temporary breach of Single Obligor limits or even Capital Adequacy levels. This strategy could however temporarily impair its liquidity until the entire chain from upfront financing to delivery and eventual sale to the off-taker has been completed.
During routine inspections, the Regulator may significantly de-classify a bank’s loan portfolio. This may lead to massive write-downs of the portfolio. In their independent function, Risk Managers, Internal and External Auditors should, therefore avoid being “mesmerized” by the value of the Loans and Advances portfolio.
For an incisive evaluation of a company’s financials, Pillar 3 of Basel 11 sets out minimum disclosure requirements under “Market discipline” for external reporting of audited published financials. Disclosure requirements are designed to afford a measure of transparency and allow analysts and investors to fully appreciate the financials. This includes the basis of accounting, the policies adopted and a bank’s potential or the inherent risks at periodic intervals.
Appropriate financial statements presentation and disclosure are key to achieving the objectives of financial reporting. Disclosures provide vital information to investors, lenders and other stakeholders. It must be underscored that even a large company like Enron fell foul of financial statements manipulation, aided by their infamous auditors, Arthur Anderson.
The Risk practitioner must therefore understand the limitations of published accounts when probing the true state of health of the firm, especially the liquidity and capital of banks. In assessing a bank’s true risk, one must consider that not all risks are specifically expressed in figures in the financial statements. To effectively analyse the strength or prospects of a modern bank, equal emphasis should be placed on critical qualitative factors as;
- The skills set, integrity and motivation of the board, management and workers (human capital) and their capacity for adaptation.
- The brand and the continuing relevance of the firm’s products or services,
- Strategic positioning or niche creation and sustenance,
- The board’s strategic outlook, including its risk management approach and corporate governance framework, anchored on the multiple expectation of key clients and other stakeholders
- Executives’ understanding of forecast economic and political conditions in the country, inter alia.
A balance between the quantitative and qualitative measures is crucial for a better understanding of the profitability and survivability of the bank under review. An investor seeking to make investment decisions must therefore recognize the limitations of “strong financials”.
Measures to deal with a liquidity crisis
Having identified the key sources of a liquidity crunch, the individual bank will apply the strategies that would adequately respond to the factors, if they are internal, while the Central bank and the fiscal authorities drive the external factors to ensure sanity in the larger financial market.
Using the “Event- Cause – Effect” model in basic risk management, helps with an understanding that a liquidity crisis may originate from either side of the balance sheet. Key remediation measures must therefore focus on the key elements in the asset or liability side of the balance sheet.
On the asset side, this may come through the ability to sell assets, discount or pledge assets at short notice without value impairment. The nature of the marketable assets and their susceptibility to price changes determine how liquid these can be.
In many cases, the sophistication of the money and capital markets play a crucial role in determining how liquid these assets can be. For instance, theoretically, securitization of a part of the bank’s loan portfolio is a feasible proposition but requires credible up-takers, whose appetite may, in part, be determined by the prevailing legal/regulatory system, interest and exchange rate dynamics.
A liquidity crisis may be ameliorated by mobilization of fresh deposit funds at short notice in the market or drawing on previously negotiated lines of credit, or when expected outflows of funds are perfectly matched by commensurate inflows of funds. This may take the form of an energized deposit mobilization scheme through raffles and other public sensitization of the bank’s profile. Infusion of additional capital by shareholders or the take up of approved tier two capital in the short to medium term can also bolster liquidity.
The management of liquidity risk is crucial to the profitability and survival of each bank and requires a strategic approach to ensure that there is neither illiquidity nor excess liquidity since each of these has varied implications on return on equity and potential regulatory sanctions.
According to the “Sound Practices for Managing Liquidity in Banking Operations” BCBS (February 2000), key principles for liquidity management are prescribed as follows:
- Developing a strategy for managing liquidity
- Measuring and managing the bank’s net funding requirement
- Managing market access
- Contingency planning
- Foreign currency liquidity management
- Internal controls for liquidity risk management
- Role of public disclosure
- Role of supervisors.
A few of these elements would be captured in the next article to illuminate their importance, respectively, and how they are affected in the bank’s bid to enhance its ability to anticipate and accommodate deposit and other assets impairments.
Structured liquidity management facilitates funding of growth in the loan portfolio and other off-balance sheet exposures, especially in the wake of IFRS 9 implementation.
This strategic function of liquidity management cannot therefore be left to chance or spasmodic reactions. It requires a concerted approach that embraces many departments of the bank; in particular, the deposit mobilization units and capital deployment units like finance, treasury, credit, information technology and branch development.
This is where the Liquidity Contingency Plan (which forms the theme of the next article) becomes an essential tool in bank liquidity management.
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
