Bank liquidity management: Defying the 2:1 current ratio in accounting ( Part III)

Bank liquidity management(Part I): Defying the 2:1 current ratio in accounting
Photo: Francis Owusu-Achampong,

Addressing liquidity concerns

From an enterprise-wide risk management perspective, all business units in the bank have a role to play during a liquidity crisis. The role of the Treasury function is however critical in the formulation of any responses to such crisis.

The inter-relationship of the treasury function with other critical liquidity generating or deployment departments like International Banking, Domestic Banking, Corporate Banking, Credit Risk, must be clearly spelt out as part of managing expansion or deliberate contraction of the deposit and credit portfolios, asset acquisitions or enhancement.

The treasury environment is controlled by a variety of internal and regulatory policies. These are designed to ensure the stability of the individual bank and the avoidance of systemic risk across the banking industry.

This is even more pertinent when considered against the backdrop that the nature of the volumes of trades transacted are relatively large, both at the individual transaction level and on a consolidated basis for any bank.

Generally, the bank’s risk appetite determines its control policy in respect of counterparties, limits of trades, and the capacities of various dealers in the treasury department. There must also be determination of periodic risk appetite based on Capital Adequacy Ratios and strategic initiatives and direction. This may affect branch expansion or other fixed assets acquisition or enhancement, depending on the liquidity gap and how soon this may be closed.

As a routine, the ALCO reviews the liquidity ladder continually with a view to assessing funding gaps. The key objective of this review is to evaluate the extent of surplus or deficits in funding requirements with a view to determining optimal borrowing or lending strategies in the money or capital market. This requires arranging the maturity patterns of assets and liabilities over different bands to ensure optimal liquidity in both local and foreign currencies.

The ALCO assesses the liquidity position of the bank by placing all the assets and liabilities of the bank into specific or desirable buckets and analyzing the net liquidity or cumulative position for each maturity band.

The resultant gap which could be positive or negative depicts the liquidity or cash position of the bank at any given period.

The cash position can be changed into desired levels by liquidating the marketable assets portfolio hence, the need to maintain optimum levels of tradable instruments. ALCO determines the cost of liquidating such assets in case of need.

As part of measures to deal with liquidity gaps identified, the bank may fall on credit support lines previously arranged with correspondents or their parent companies under previously held Letters of Comfort and similar such arrangements.

The ailing bank may engage in aggressive pursuit of new liabilities with a focus on raising term funding, fresh capital injection especially from Corporate, Pension funds, Insurance Companies and Multilateral lenders, or sale-lease back arrangements that release tied up capital into cash flows.

Depending on the severity of the crises and the responses of market participants, a freeze on further asset acquisition and a lull in credit expansion may be considered viable alternatives, so is a resort to the central bank as a lender of last resort.

In meeting the ALCO objectives mentioned in previous articles, ALCO is constrained principally by two forces- internal and external.

Internally, ALCO policies must be consistent with its growth, profitability and risk appetite objectives. This is further underlined by:

  • the structure of the bank’s balance sheet- its capital and reserves, loan/deposit ratios, maturity profile of assets and liabilities, on and off- balance sheet exposures.
  • the sources of funding available to the bank- their consistency of flow, cost and concentration dynamics
  • the development and use of a Liquidity Contingency Plan (LCP), which is explained in-depth below
  • the nature of assets that have been created from prior funds- the embedded or peculiar risks associated with them, their respective tenor and sectoral concentrations.

The more assured the sources and quantum of funds availability are, the easier it is for ALCO to adopt an aggressive assets and liability management approach. The mix between local and foreign currency assets and liabilities equally has a strong influence on how ALCO conceives and executes its functions.

Retail banks tend to have consistent and low-cost funds (deposits) than corporate/investment banking units. Hence, the individual bank’s approach to liquidity crises management may be slightly different.

On the external front, banks which operate in jurisdictions where the Central banks require   specific primary and secondary reserves are constrained in the extent of use and application of funds. The higher the reserving requirements, the more the bank is constrained in its allocation of funds for credit and investment purposes.

This explains why in the height of the covid 19 pandemic, Bank of Ghana reduced the universal banks’ primary reserves from 10% to 8% in a bid to freeing liquidity for businesses.

In other countries, there may be no or easier reserving requirements. Instead, banks (as in the United States), may be forced to subscribe to the Federal Deposit Insurance Corporation (FDIC) which may have its own prescriptions. These will cumulatively affect banks’ responses to liquidity crises in such domains.

Other liquidity mitigating measures.

Through early identification of an imminent liquidity crisis, the bank would most likely possess superior knowledge over the market. The liquidation of assets must be performed discreetly, as a loss of confidence might be triggered or worsened if the providers of funds suspect a forced sale situation.

In the short period, at least, the bank would be in a position to increase its liquidity buffer through the drawdown on committed and uncommitted bi-lateral funding lines.  A bank in liquidity crisis may also aggressively pursue new liabilities, focusing on raising term funding especially from corporate, pension funds, insurance companies and multilateral lenders.

The bank must be conscious though, of how the market perceives its bulging appetite for borrowing, particularly if it is coupled with a sudden willingness to pay off-market rates for liability products. An illiquid bank may issue debt or engage in securitisation programmes through a Notes or Bond Issue with the regulator’s approval.

Other core strategies to manage liquidity pressures during a crisis may involve the progressive sale and/or repo of available unencumbered liquid assets in excess of minimum prudential requirements. For example, liquidity may be available from the selling and/or repo of secondary marketable assets (Treasury Bills, Negotiable Certificates of Deposit, Promissory Notes and other instruments with similar characteristics).

The stressed bank may decide not to roll over overdrafts when due or may call funds repayable on demand. It must be conscious, though of the signal this might send to the market and the implications on client relations, especially the potential to elicit negative signals in the market.

The sale of securities designated as held-to-maturity (‘HTM’) should be limited to extreme stress levels, as this could taint the entire HTM portfolio resulting in a requirement to mark-to-market the portfolio.

Instead, HTM securities can initially be used to generate liquidity via entering into repurchase agreements with institutions like SSNIT. And other Pension Funds. Securities designated as available-for-sale (‘AFS’) should be done with due consideration of market liquidity in the various asset classes and realisable market values during a forced sale situation.

In the main, however, banks activate measures prepared and approved by the Board in a Liquidity Contingency Plan. This is owned and executed primarily by the bank’s ALCO and explained fully below.

Liquidity contingency plan.

A Liquidity Contingency Plan defines the bank’s broad liquidity response strategy. It provides a checklist that ensures that a structured and comprehensive approach would be followed in dealing with a liquidity crisis. The plan identifies the bank’s contingency liquidity sources and ensures that the relevant considerations are applied to liquidity generation and application.

In setting out what could trigger a liquidity crisis, attention must be paid to the balance sheet structure, emphasizing the various components and their peculiar characteristics. In particular ambiguous liability product classes are known to exhibit behaviour inconsistent with the contractual product definition.

In formulating a liquidity crisis response, the bank must consider the nature of the liquidity crisis, the available sources of liquidity, and the sophistication and regulatory framework of the domestic market.

These must form the bedrock of the contingency plan which must be communicated to all parties to enable the various units in the bank to move in sync with recommended strategies. This is even more pertinent when a freeze on further loan expansion must be promptly enforced and capital expenditures halted.

Contingency plan objectives

Generally, the Liquidity Contingency Plan aims to mitigate the impact of a liquidity crisis by establishing a governance framework. This details the bank’s response to a liquidity problem and includes the use of Early Warning Indicators (EWIs), or a methodology covering potential causes of a liquidity crisis.

A thoroughly crafted plan permits an understanding of the impact a liquidity crisis might have on up- and downstream stakeholders. It must provide guidelines for limits/ tolerance levels acceptable, including reporting and escalation procedures.

Key decision support data must cover trends in the Top 20 Borrowers ratio; Top 20 Lenders ratio, movements in contingent liabilities, periodic evaluation of triggers for calling up Standby Letters of Credit, Avalised Bills of Exchange, Promissory Notes Issued, Other Bonds and Guarantees issued and outstanding. These have grave liquidity implications.

The plan must also specify sources of funding to bridge gaps when they occur. Gap management would incorporate the lender of last resort principle in the event that the bank fails in its efforts to effectively deal with a liquidity crisis if the causes are too overwhelming or the Bank lacks sufficient capital.

Depending on the gravity of the liquidity crises and market participants’ perceptions of an individual bank’s problems, lending to the afflicted bank may be frozen, even when the latter is willing to pay off-market rates for incessant borrowing. This may be perceived in itself as an admission of a near insolvency position.

The Liquidity Contingency Plan will broadly cover board approved guidelines on such critical issues as:

  • Structural liquidity mismatch limits and guidelines
  • Foreign Currency lending limit and a net Open Position threshold
  • Minimum levels of surplus marketable assets (beyond regulatory requirements)
  • Depositor concentration risk
  • Market sector funding sources, including key inter-bank sources and the Lender of Last Resort principle.
  • Daily Cash flow management
  • Liquidity stress testing, including laddering of liabilities in time bands to quickly identify gaps requiring immediate remediation
  • Key roles and responsibilities of identified internal and external stakeholders.

Criticality of communication flow.

Recognising that banking thrives on trust and responsibility, frantic internal measures must be undertaken to stem a liquidity crisis. The place of effective communication to critical stakeholders and the content of such communication requires expert handling.

A structured communication strategy must be formulated as an essential component of the liquidity crises management. In particular, the bank’s strategy must effectively address adverse public perception and deteriorating customer confidence, with the tacit support of the central bank.

Ideally, this critical step must include determining what facts to disclose to the providers of funds, customers, the media, rating agencies, board members and staff. Expectedly the central bank would already be aware of the crisis and may have reluctantly engaged in regulatory fore-bearance against the broad objective of ensuring that a bank specific crisis does not metamorphose into a systemic problem for the industry- the risk of contagion.

Equally important is the timely distribution of information using suitable channels eg, press statements and email from an appointed source to ensure consistency and credibility.

A structured approach must be implemented to avoid signalling to the market the existence of a seemingly intractable problem. Major depositors, especially must be well informed through money-market dealers and other counterparties, while senior bank officers liaise with other banks to minimize the effects of the crisis.

The conventional secrecy and confidentiality of bank information must be reinforced such that bank staff are made to remain silent about the nature and causes of the crises. Information must be concentrated in a designated group of senior officials for consistency and credibility.

Regulatory interventions

The Central Bank determines the nature and depth of assistance it may offer a bank in liquidity crisis and the conditions it may impose against any such gesture. To minimize contagion effects, the central bank would almost invariably cooperate under its lender of last resort mandate.

A menu of regulatory approaches may be available at the discretion of the central bank.  Regulatory assistance may come in the form of a temporary waiver of the prudential liquid asset requirements in order to enable the stressed bank to survive the crisis. The central bank may also temporarily waive its prudential cash reserve requirement in order to enable the bank in distress to settle its obligations to counterparties on the money market.

Direct short-term loans and explicit government guarantee of deposits may also come to the fore where the Bank is considered to be systemically significant in the local financial market. Other regulatory measures may include a request to the shareholders to inject new share capital; provide credible alternative plans to weather the storm.

This may include securitisation of assets; a freeze on loan expansion, merger with another bank; and actions deemed appropriate by the Central Bank, as was the case with the defunct UT Bank Ltd and Capital Bank which had to collapse in view of their precarious nature of their respective balance sheets.

Per s. 36 of the BSDTI Act 930, (1) A bank, specialized deposit-taking institution or financial holding company which fails to hold liquid assets in accordance with section 36 is liable, in addition to any other penalty, to pay interest to the Bank of Ghana at a rate to be prescribed by the Bank of Ghana on the difference between the total amount of liquid assets which it is required to hold and the total amount of liquid assets actually held, in respect of a period during which a difference exists.

Further sanctions include:

(a) discontinue or limit in a manner specified, the granting of credit or the making of investments or capital expenditure;

(b) not distribute dividends to shareholders; and

(c) be subject to enhanced reporting.

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


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