Tiểu luận assignment LIQUIDITY AND RESERVE MANAGEMENT STRATEGIES AND POLICIES

NATIONAL ECONOMICS UNIVERSITY COMMERCIAL BANK ASSIGNMENT TOPIC: LIQUIDITY AND RESERVE MANAGEMENT: STRATEGIES AND POLICIES Teacher: PhD DO HOAI LINH Group : BÙI VIỆT ANH PHẠM TÂM LONG NGUYỄN HỮU BẢO ĐỖ KHÁNH HUYỀN HOÀNG PHƯƠNG QUỲNH Ha Noi 2017 Contents I Liquidity risk: II Definition of liquidity of bank: Definition of liquidity risk: According to Basel committee on Banking Supervision: The risk that a financial institution is unable to find sufficient funds to meet its maturing obligations without affecting its day-to-day business operations nor affecting its financial position 3 The relationship between liquidity and bank reserves: Reason to happen liquidity risk: 4.1 Model of supply of and demand for liquidity: 4.2 The reason of happen liquidity risk: III Management of liquidity risk of bank: Signals from the marketplace: How to prevent liquidity risk: 2.1 Estimating liquidity needs: 2.2 Principle of management and supervisor of liquidity risk 12 2.3 Prevent liquidity risk: 12 Control the status of liquidity of banks 14 The way to surmount deficit of net liquidity position: 16 4.1 First strategy 17 4.2 Second strategy: Borrowed liquidity management strategies: 17 4.3 Third strategy: Balanced liquidity management strategies: 17 I Liquidity risk: Definition of liquidity of bank: - - According to Basel committee on Banking Supervision: Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses => Liquidity of bank depends on the demand and supply of fund in the financial market Bank uses model of demand for and supply of liquidity to determine net liquidity position at any moment in time and set the plans to use funds Definition of liquidity risk: According to Basel committee on Banking Supervision: The risk that a financial institution is unable to find sufficient funds to meet its maturing obligations without affecting its day-to-day business operations nor affecting its financial position The relationship between liquidity and bank reserves: - - When the bank falls short of liquidity, the bank's reserves will finance the deficit in the short term In addition to the cash in vault, the bank needs to reserve a premium for this type of risk Liquidity risk is the type of risk mentioned in Basel II's minimum capital requirements, and needs to be carefully assessed by the bank and monitored by the central bank Reason to happen liquidity risk: 4.1 Model of supply of and demand for liquidity: a) Supply of liquidity:  Definition: is the amount of money that already have or going to have in the short period of time for bank in using purpose  This cash flow comes from :  Customer’s deposit Considered to be the most important source of supply for the liquidity The more deposits bank has, the more liquid bank will be Bank could adjust the interest rate that attract people’s deposit  Customer’s loan repayment Second important of all, Lending is the main activities of bank, bring back the highest profit for bank but also come with the greatest risk -> affect the ability of payment of bank If every loans have been paid, it not just bring profit to bank but also be a great source of liquidity for bank  Borrowing from the money market: Bank could increase the supply of liquidity by borrowing from the money market, including new loans, extend the due date, … borrowing from other bank and also from central bank  Sales of assets : - To meet the liquidity demand, bank could sell their assets + Revenues from the sale of nondeposit services: - Is the amount of money that bank has received through the process of serving the customers : Opening L/C … + Issuing securities to the market:  Bank issuing stocks to the market is a great source of liquidity for bank b) Demand for liquidity:  Definition: is the demand for withdraw the money out of bank in different time  This demand depends on these elements:  Demand on withdrawing the money of customers This demand is frequent, immediately, including deposit with no terms, payment deposit and deposit with terms and can withdraw before the maturities In deposit with no term and payment deposit, bank have to secure the amount of reserve money in the account to meet the demand of withdrawing Elements that create demand of liquidity could be the rate of inflation in the economy, fluctuation in channeling funds interest rate between banks  Credit request from customers: This is also an element that has great influence to liquidity demand It comes from the demand of investing from investors, competitive interest rate between banks -> Harder to approach the funding sources  Repayment of nondeposit borrowing This is the amount of money that bank have to repay the debt from borrowing financial institution, Central bank,…  Interest expenses: These are costs that have to pay through mobilizing funds, interest through issuing valued paper  Payment of stockholder cash dividends: The amount of money that banks have to pay to their stock holders 4.2 The reason of happen liquidity risk: There are a lot of causes lead to liquidity risk and it comes from all sides of bank’s business activity: from subjective, objective; from the bank itself, from the customer, the policy, from the other types of risks, etc However, in terms of researching to find an effective solution to liquidity risk management, the following main reasons can be deduced: a) Subjective reason:  Due to the maturity of asset and liability are disproportionate, because of the converting maturity function of the bank: mobilizing short-term deposits from the public for long-term loans So asset's term is longer than liability's term, making asset's cash flow not equal to the cash flow needed to meet the maturity of liability, causing difficulties for banks to find the source for compensation  Risk of imbalance in asset structure This comes mostly from the short-term profit pressure of shareholders on the board of directors, which forgot the principles of asset and liability management In their asset portfolio, commercial banks invest in stocks and bonds, most important of which are government bonds and / or Treasury bills Although, interest rate of Government bonds and Treasury bills are not attractive but they are easy for commercial banks to discount at the central bank when occurring liquidity risk Any commercial bank, especially small banks, understands this, but with their weak financial, it is difficult to compete with big banks in the auction of government bonds and treasury bills  Customer structure is not reasonable Bank just concentrates on potential customer’s credit or a proportion of one sectors, an area which occupy a large proportionof total liability Or in total mobilizing a customer having a large proportion, When these customers are having difficulty in paying off their debts on time or unexpectedly withdrawing, this leads to an liquidity risk  Because banks are pursuing profit targets in short term, there are overly open lending policies that lead to lower lending conditions, loans to underprivileged borrowers As the consequence, it leads to credit risk and liquidity risk  Because banks not estimate the need of withdrawals or obligations to pay When demand for withdrawing money and performing obligations exceed their expectations, these banks will face liquidity problems  As the financial capacity of banks is limited Charter capital is the amount of capital owned by the bank, which is formed when the commercial bank is established It reflects the scale or financial capacity of commercial banks The higher capital of the commercial banks have, the bigger potential finance of the banks are On the contrary, the lest the bank's charter capital has, the smaller the size of the bank Small banks often find it difficult to access sources of capital, or only with high interest rates, especially for loans It can be said that there is a huge pressure when these banks have to bear the high cost to overcome difficulties in solving liquidity problem The small scale of charter capital may be one of the reasons that pushes commercial banks to insolvency and bankruptcy when demand for liquidity increases suddenly  Due to the multiple currency trading, it is created the liquidity risk and financing requests each currency  Due to the reduced of bank’s prestige, the depositors quickly withdraw the deposit causing the liquidity risk This is the consequence of the weak business, the PR team has not been sufficiently invested b) Objective reason:  Financial assets are susceptible to fluctuations of interest rates Interest rates change leads to a great effect of depositor’s psychology In case of rising interest rates, customers will withdraw money to deposit at other banks with higher interest rates, while borrowers will minimize new borrowing to avoid paying higher interest When interest rates fall, the reaction is reversed In both cases, fluctuations in interest rates affect both deposit and loan cash flow, ultimately affecting the liquidity of banks In addition, the change in interest rates will affect the market value of selling financial assets and the cost of borrowing in the monetary market  Monetary policy of the central bank To perform its function in managing monetary policy, the central bank uses three instruments, including open market operations, reserve requirements, discount rates and rediscount of valuable papers - Open market operations (OMO) are the activities of central banks to buy or sell commercial banks and treasury bonds to commercial banks When wanting to increase the money supply, the central bank buys bonds from commercial banks, the money that the central bank pays to commercial banks increases the money supply for the economy and also increases the supply of liquidity to commercial banks On the contrary, in order to reduce the money supply, the central bank sells bonds to commercial banks, the money that the central bank collects reduces the money supply of the economy and also reduces the liquidity supply of commercial banks - The required reserve ratio is a regulatory measure that central banks require commercial banks to maintain a minimum reserve requirement ratio at the central bank If the required reserve ratio is high then the supply of commercial banks liquidity increases and vice versa - Discount and rediscount rates are the interest rates the central bank uses in the discounting or rediscount the value of commercial banks’ paper If this interest rate is low, this will be the cheap capital fund that commercial banks can easily mobilize to meet the liquidity demand  Legal framework of operational safety in credit institutions system The mechanisms, policies and legal documents related to banking operations are clearly and specifically issued as well as the operation of the bank’s supervision agency, the close coordination between “remote monitoring” and “site inspections” will contribute to ensuring the safety of the NH system  Due to the customer's business cycle According to seasonality at the end of year, businesses will speed up their business activities, settle debts to other companies, pay compensation to employees, make commitments to disburse money to partners, solve Inventory, import of goods creating a large demand for money in the last months of the year, which increases demand for liquidity for commercial banks  Due to the special characteristics of the cycle business Cycle business requires that commercial banks are always ready to meet the demand for immediate loans For other businesses, company can delay debt with customers, pay tardily with partners, even can proactively occupy the capital of business partners But for commercial banks in the sensitive monetary, commercial banks can not delay payment Any payment delays can cause anxiety in the public, and if the commercial bank does not solve this problem right away, the customer can go to the bank to withdraw money leads to the liquidity problem If this situation becomes more and more seriously, commercial banks may go bankrupt On the other hand, on the balance sheet of commercial banks, the liability always has a certain percentage of demand deposits and term deposits but can be withdrew before its maturity This is the liability that the commercial banks are obliged to pay immediately if the customer needs to withdraw, so that commercial banks are always ready to meet liquidity needs   Due to economic crisis or financial crisis The economic or financial crisis has led to rising costs of mobilization, reducing lending and investing efficiently On the other hand, the crisis may undermine the belief in the financial system, organizations and residents will withdraw money from commercial banks causing liquidity pressures on commercial banks Due to rumors Bad rumors will lead to distrust on a particular financial institution The mechanism of imbalance between the value to be paid and the value earned from investment and lending activities will occur so that commercial banks will face liquidity risk II Management of liquidity risk of bank: Signals from the marketplace:       Public Confidence Institution losing money: is it because of the public perception that it will be unable to pay its obligations Stock Price Behavior Falling stock price may indicate of liquidity crisis Risk Premiums on CDs and other borrowings Payments of higher interest on these liabilities may be considered as risk premiums and liquidity crisis Loss Sales of Assets Sales of assets in hurry (with significant losses) again may indicate of liquidity crisis Meeting Commitments to Creditors Is it able to honor all requests for potential profitable loans? Borrowings from the Central Bank Borrowing in large volume and more frequently from the central bank indicates liquidity crisis If problems exist in any of these areas, management needs to take a close look at its liquidity management practices to determine whether changes are in order How to prevent liquidity risk: 2.1  Estimating liquidity needs: Method 1: The sources and uses of funds approach The key steps are: Step 1: Loans and deposits must be forecast for a given liquidity planning period Step 2: The estimated change in loans and deposits must be calculated for the same period Step 3: The liquidity manager must estimate the net liquid fund’s status for planning period by comparing the estimated change in loans to estimated change in deposits At the first step, There are two way to estimate loans and deposits at a given liquidity planning period The first way: Bank uses econometric models to estimate the forecast of loans and deposit by using the variables The variables will be collected in the past of all party that take part in the process of take deposit and make loans of bank They are variables that affect to the deposits such as income, interest rate of deposit, and the loans such as GDP, inflation, interest rate of loan, => - Difficult to obtain the data and deploying model - Spend a lot of money to use the model The Second way: Use statistics in the past of internal of bank and estimate the forecast of sum of deposits and loans Bank divide sum of deposit and loan at any time into part: - Trend component: Estimated by constructing a trend line using as reference points year-end, quarterly, - Seasonal component: measuring how deposits and loans are expected to behave in any given week or month due to seasonal factors - Cyclical component: Representing positive or negative deviations from a bank’s total expected deposits and loans, depending upon the strength or weakness of the economy in the current year Sum of deposits or loans expected = sum of deposit or loans in before period + trend component + season component + cyclical component => Easy to collect the data and deploy model Step 2: Calculate the change in expectation in planning period - According to forecast model: delta (change sum of loans) = f (GDP, interest rate of loans, inflation, ) delta (change sum of deposits) = f(income, interest rate of deposit, )  - According to data of internal bank model: change in loans or deposit = total loan or deposit expected in coming period - total loan or deposit in before period Step 3: Determine the net liquidity position: Estimated net liquidity position = estimated change in deposits - estimated change in loans Method 2: The structure of funds approach: Managers of liquidity risk only take care of demand for liquidity, not have care about supply of liquidity The sources of fund are divided into many group, depend on ability of withdrawal, and reserve of each group is different Step 1: Divide fund into group depend on the ability of withdrawal - Hot money liability: deposit and other borrowed funds that are very interest sensitive - Vulnerable funds: customer deposits of which a substantial portion - Stable funds: funds that management consider unlikely to be removed Step 2: Determine reserve for liquidity of each group: Liability that has high ability of withdrawal will has high proportion, and the bank needs to hold high money for liquidity of this liability 95% to hot money liability after minus legal reserve held 30% to vulnerable funds after minus legal reserve held 15% to stable funds after minus legal reserve held Step 3: Estimated liability liquidity reserve: A = 0,95 x (hot money liability - legal reserve held) + 30% (vulnerable funds - legal reserve held) + 15% x (stable funds - legal reserve held) Step 4: Estimate liquidity for increase the maximum of credit operation - Bank should hold an amount of reserve enough to increase the credit operation because of profit of bank and relationship with customer Bank should hold amount reserve B equal Potential loans outstanding minus actual loans outstanding Step 5: Estimate total liquidity requirement Total reserve for liquidity = A + B Step 6: Bank use stress testing to make many scripts with many ability happen so as to estimate demand for liquidity of each script 10  Liquidity indicator approach: Bank can calculate indicators of liquidity to estimate their liquidity needs, and compare with other bank in banking system to adjust for There are some liquidity indicators that are important for bank to estimate liquidity needs a) Indicators about asset of balance sheet - Cash position indicator: cash and deposit due from depository institutions / total assets -> This high indicator reflects good liquidity for bank, but cash and deposit in other depository institutions are unprofitable money, so bank should maintan this indicator at a reasonable level, both profit and liquidity - Liquidity securities indicator: Government securities/ total assets Government bonds are free-default risk bonds, highest liquidity in each country and take the interest for bank -> Bank should maintain this high indicator so as to prevent liquidity risk, special the economy has bad debt - Capacity ratio: Net loans and leases/ total assets -> The high capacity ratio tends to decrease the liquidity for banks because net loans and leases are illiquid of assets b) Indicators about liability of balance sheet: - Deposit composition ratio : demand deposits/ time deposits -> This ratio measures how stable a funding base each institution possesses A decline ratio suggests greater deposit stability and lesser need for liquidity c) Indicators about both liabilities and assets of balance sheet: - Core deposit ratio: Core deposits/ total assets -> Core deposits are primarily small checking and savings accounts that are considered unlikely to the withdrawn in short term -> High ratio suggests lower liquidity requirements for bank - Hot money ratio: (cash and due from deposits held at other depository institutions + short term securities + Fed funds loans + reserve purchase agreements)/ (CDs + Fed fund borrowing + repurchase agreement + Eurocurrency deposit) -> This ratio reflects relationship between assets and liability of bank in money market or sensitive assets and sensitive liability of bank -> The high ratio reflects bank has enough assets that can be sold to meet the 11 need to withdraw funds from money market 2.2 Principle of management and supervisor of liquidity risk: According to the “Principles for sound liquidity risk management and supervision” of Basel committee to guide banks on risk management, there are 17 principles, they belong to groups: - Governance of liquidity risk management: -> Bank must have model apparatus for liquidity risk, and the senior management of bank should develop a strategy, policies and practices to manage liquidity risk - Measurement and management of liquidity risk -> Bank should have model to estimate liquidity risk and conduct stress tests on a regular basis for variety of short-term and long-term so as to identify sources of potential liquidity strain + Public disclosure + The role of supervisors 2.3 Prevent liquidity risk:  Liquidity risk management model About the risk management structure There are main elements The frame The infrastructure The risk management steps According to the Basel Committee on Banking Supervision: "Risk management must be a continuous process at all levels of Commonwealth of Independent States and play an important role in the achievement of goals, Finance and debt 12 repayment of that organization " From analyzing the organizational structure constraints in the liquidity management of commercial banks, in order to improve the liquidity management capacity of commercial banks, the responsibility should be divided into rounds as follows: To manage risk in banking operations, banks need to set up an organizational structure to divide management responsibilities with each type of risk One of the risk management systems that has been successfully applied in modern commercial banks and widely recommended by international experts in Vietnam is the three-round protection model - Control round 1: Branches where direct business and risk exposure will be in the first round of control on the management of business plan formulation and implementation, capital balance and usage - Control round 2: ALCO department coordinates with the Liquidity risk management department of the Risk management unit which responsibles for building the system, rules, procedures, guidelines for liquidity management; construct , Propose setting limits, monitor and control the liquidity of units in round and independently report liquidity condition to the board - Control Round 3: 13 The internal audit department is responsible for periodically and irregularly inspecting and supervising the implementation of liquidity management to ensure full and effective implementation of the two rounds above We can call this a modern liquidity risk management model The first is the business department The second is the risk management department The third is the internal audit department The Risk Management Council (RMC) under the Board of Directors supervises and set the overall policy, the limits of all the bank's risk, which must include liquidity risk This council is also responsible for assisting the BOD in determining the risk appetite for the entire bank The asset-liability management system is responsible for managing the balance sheet structure or achieving the greatest profit but still ensure compliance with the general direction of risk of the bank, which has a major role in managing liquidity risk of the bank Relevant departments in this system include:  Asset-Liability Committee - The ALCO is the main responsible agency for the operation of the ALM, which may include Board ALCO and Management ALCO Small and medium banks operating in only one country may only build one ALCO at the management level  ALM unit / desk is where applies and develops risk management program; Identify, measure and track the balance sheet as well as the liquidity risk (and interest rate risk) from the business activity of the capital department ; Verify the appropriateness of the annual Liquidity Risk Management policies and procedures and make recommendations on the Liquidity Risk Limits ALM is also a department that conducts affordability and case analysis tests ALM has strength in financial sector, risk management sector or capital sector of the Bank, but ideally remains in the financial or capital block  Funds department, under the direction of the Executive Board, may include (but are not limited to) sales departments and ALM departments Business units are responsible for the bank's currency and capital business, providing regular data to the ALM  The internal control department functions independently from the risk management system, performs inspection and evaluation of the effectiveness of risk management policies and frameworks; Ensure the compliance of the risk management process and the quality and content of measurement methods Control the status of liquidity of banks 14 To control the liquidity of banks, we set up a process to manage liquidity risk The general procedure for managing the liquidity risk of a commercial bank can be described in this figure Quản trị khoản Lập Thang đáo hạn luồng tiền đo lường „Khoản g cách dự kiến“ Step 1: Set the maturity ladder Định nghĩa yếu tố rủi ro Phân loại luồng tiền Giới hạn Trình bày kết Báo cáo Thử nghiệm lại, thử nghiệm căng thẳng Đo lường kết hoạt động Xác định thời gian dài hạn “Khoảng cách dự kiến” The first step in setting the maturity ladder is to build the liquidity flows of the commercial bank This can be done through the steps described in the following diagram Define cash flows arising during the operation of the BANK as risk factors Classify the identified cash flows and distinguish identified and random cash flows Define time intervals depending on the term of the products which are being used (short, medium, long term), such as daily up to month maximum, weekly up to months maximum, monthly up to year maximum , over that is annual - Based on historical data, the BANK categorizes Gaps of random cash flows with short and medium term bands - Calculates potential changes of risk factors from historical scenarios 15 - Calculates the probability distribution of risk factors for specific time bands based on these scenarios - Presents the probability of distribution function - Calculates cash flows for each time band, with seasonal impact in mind with the help of a historical simulation - Summary of identified and randomized cash flows for each time band - Determine the cumulative cash flow limits for the specified time bands Basically, the limits for short and medium term bands are based on liquidity changes and experience of "potential gap exposures" Step 2: Create/Write liquidity report - The Bank should prepare a daily report on results of cash flow forecasts, which will identify cumulative cash flows, cumulative reserves postage, cumulative Gaps, changes in limits, and cumulative "cushioning" - A liquidity cushion relates to a business or individual holding an ample amount of cash, or other highly liquid assets, in relation to debt, so that a short-term liquidity crunch or other unexpected event will not lead to potentially disastrous consequences - The daily liquidity report of the BANK is scheduled for a period of time Example: Các luồng tiền cộng dồn Dự trữ vốn khả dụng cộng dồn (+) Hạn mức Gap cộng dồn “Lớp đệm" cộng dồn T+1 T+2 -1.250 T+3 đến15 1.400 Từ 30- 60 Từ 61- 90 Từ 90- Từ 180 >181 -1.600 -1.500 1.000 2.000 1.500 3.030 4.030 3.830 3.830 3.530 3.500 3.500 1.500 4.530 3.030 1500 2.780 1.280 2.000 5.230 3.230 500 2.230 1.730 2.030 2.030 300 4.500 4.200 1.200 5.500 4.300 The way to surmount deficit of net liquidity position: The bank needs to understand that the amount of capital held for liquidity is a source of unprofitable capital and even if the bank holds a certain amount of capital to cover liquidity risk, a market shock can cause the bank to use up all that capital to offset the liquidity -> Bank should have strategies for liquidity managers from manager asset and liability of itself instead of a holding amount of capital for the liquidity risk because liquidity risk will affect assets and liabilities first 16 4.1 First strategy  Asset liquidity management strategies: + Bank should to hold the liquid assets and be profitable When bank needs liquid, can buy and discount them to receive money Example: Discount Treasury bills to Central Bank  Assets that bank should hold: - Treasury Bills - Fed funds loan to other institutions - Purchase of liquidity securities under a repurchase agreement - Placing correspondent deposits with various depository institutions - Municipal bonds and notes - Fed agency securities - Negotiable certificates of deposit - Eurocurrency loans -> Treasury Bills were used widely in banking system because the liquidity of them is very high and central bank usually helps bank to supply funds for liquidity by buy T.Bills with role of last borrower for commercial banks 4.2 Second strategy: Borrowed liquidity management strategies: - When bank needs liquidity, bank can borrow from central bank and other commercial bank through discount window or interbank market This solution was used widely because time for transfer money in interbank market is fast and the loans from borrow in interbank market mainly shortterm loans, so banks with idle funds also want to lend for other bank needs liquidity so as to receive high overnight rate and the relationship among banking system Bank can borrow from sources: Fed fund borrowings Selling liquid, low risk securities under a repurchase agreement Issuing negotiable CDs Issuing Euro currency deposits Securiting advances from the Federal Home loan bank Borrowing reserves from discount window of central bank 4.3 Third strategy: Balanced liquidity management strategies: - Under a balanced liquidity management strategy, some of the expected demands for liquidity are stored in assets, while other anticipated liquidity needs are backstopped by advanced arrangements for lines of credit from potential suppliers of funds - Long-term liquidity needs can be planned for and the funds to meet these needs 17 can be parked in short-term and medium term assets that will provide cash as those liquidity needs arise 18 ... between liquidity and bank reserves: Reason to happen liquidity risk: 4.1 Model of supply of and demand for liquidity: 4.2 The reason of happen liquidity risk: III Management. .. 4.2 Second strategy: Borrowed liquidity management strategies: 17 4.3 Third strategy: Balanced liquidity management strategies: 17 I Liquidity risk: Definition of liquidity of bank: - - According... Governance of liquidity risk management: -> Bank must have model apparatus for liquidity risk, and the senior management of bank should develop a strategy, policies and practices to manage liquidity