Importance Of Bank Liquidity Risk Management And Supervision Finance Essay

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Traditionally banks face liquidity risks as a result of the maturity transformation. However with the innovation of financial markets banks have also been altered its practices and exposure to liquidity risks during the last two decades. It was significant the accumulation of activities between banks and financial markets. Using highly complex securitisations such as collateralised debt obligations, highly usage of market funding and increase it's lending to highly leverage financial institutions such as hedge funds can be determined as examples for the growth of the relationship with financial markets.

Since the changes in banking, the regulators mainly paid more attention to manage credit risks, market risks and operational risks. However with the implementation of Basel II the capital adequacy requirement was the key element of banks modern risk management. Bank of International Settlement (BIS) has defined the guidelines to measure capital adequacy. The 2007-2008 financial crisis illustrated that how regulators failed to perform their responsibility and showed the impact of liquidity dried up in financial markets and in banks.

The aim of the paper is to analyse the importance of liquidity risk management in the banking industry, mainly in UK, USA and Europe and the importance of regulators and supervision towards bank liquidity risk management. Moreover it is discussed the causes for liquidity risks and how it could be managed prudently in the light of the recent financial turmoil.




Banks play an important role in the economy such as financial intermediaries that form products and securities to facilitate exchanging of funds between the surplus and the deficit units. With the change of financial environment over the last few decades it can be seen that it has led to a vital vulnerability towards risks. Market risk, Operational risk, credit risk and liquidity risk etc can be identified as main risks associated with the banking industry.

Banks face the liquidity requirements by collecting deposits and raising financial debts. The fundamental role of banks in the maturity transformation is to convert short term deposits into long term loans and it leads banks towards liquidity risks as a nature of an institution and that affects financial markets as a whole (Bank for International Settlement; Monetary and Financial Stability). On the other hand, there are drawbacks of keeping more liquid assets; as those assets provide a significantly low return such as short term risk free rate. As a result of highly liquid short term financial markets, including the Inter Bank Market, it can be seen that banks paid less attention managing liquidity risks in the recent years (Bessis J. 2010). However with the current crisis (subprime) most of the financial institutions, regulators and central banks have become highly aware of managing liquidity as it's been identified one of the main issues that is extremely be conscious and connected to crisis.

Moreover it can be determined effective and prudent liquidity management provides the ability of a bank to meet its cash flow obligations.


Since 1988 regulators (FSA UK, Bank of International Settlement etc..) have paid a plenty of attention and have defined international standards for banks in the areas of market, operational and credit risks. But they have either ignored or paid less attention towards liquidity risks (Sharma P. 2004).

Moreover, historically in 1930 and 1970, liquidity risk was the main cause for several major banks failure in UK and US which lead systematic inconsistency towards financial contagion. Additionally, according to the basic business model, the importance of liquidity risk management in banking industry can be clearly identified as one of the fundamental risk that arises in banking (Sharma P. 2004).

However, followed by the worst financial turmoil ever, there are many questions to be asked. Many researchers have determined it merely as a "liquidity crisis". Moreover Collapse of several high profile Banks in UK and USA, emergency bailout of other banks by governments, difficulties in making capital, deteriorating millions of dollars, departures of CEO's and CFO's of the Banks, have given a significant pressure on financial markets as well as global economies.

If the recent financial turmoil and the existing failure of banks have been led lack of liquidity, it's essential to pay more attention in managing liquidity in the banking industry to prevent future deficiencies. At the same time the requirement of regular supervision has also been identified by financial regulatory bodies (FSA in UK, Basel Committee), Central Banks and financial Institutions. However it's essential to investigate whether the regulations are adequate to meet the exposure to liquidity risk and they are properly supervised.

Although some banks who failed to manage their liquidity positions during the financial crisis have passed the guidelines for managing liquidity risks by both Bank of International Settlements (BIS) and the Institute of International Finance (Cuthber B.and Vander D. 2008). Therefore it can be determined, that there were inconsistencies with the procedures and measurements determining liquidity risks as well as lack of regulations and supervision. After facing the worst crisis ever, most of the financial institutions, Central Banks and regulatory bodies declared to make liquidity as important as capital and to manage and measure liquidity risks precisely (Blair-Ford S. 2009). Therefore it proves the requirement of adequate regular supervision in liquidity management in the banking industry.


Purpose of this paper is to determine the importance of managing and supervising liquidity risk prudently in the banking industry. At the same time it is described the responsibility over financial regulators, central banks and financial institutions towards managing liquidity risks.


In the literature, the chapter two has been briefly discussed the main risks associated with the banking industry such as credit, market and operational risks that treat as the prudential risks in banking and has been identified the relationship between those risks and liquidity risks in banking.

Moreover liquidity risk has been defined according to Bessis J (2010) and Adrian and Shin (2008). It's also identified the asset liquidity and funding liquidity in banking industry. Some of the examples have been presented such as the collapse of Northern rock, Lehman brothers and the Banks' participation of government asset protection scheme in the light of the financial turmoil 2008.

Mismatching long term assets with short term liabilities have been determined as the main cause of financial institutions@ liquidity risks. With the innovation of financial markets and instruments, the creations of Special Purpose Entity (SPE) and Mortgage Back Securities have given a significant impact on liquidity risks.

Moreover the impacts of following towards liquidity risk have also been discussed in the literature.

Volatility in Inter-Bank Markets

Valuation process of Assets in Old and New Banking system (there is a correlation between liquidity and solvency through the valuation process of securitised assets)

Off balance sheet items

Adverse effects of accounting standards

The adverse effect of collateral-based leverage

Inefficient practices of Governance of banks

Compensation culture/ remuneration policy is too oriented towards profitability

Lack of supervision of Central Banks, and regulatory bodies

Additionally it has been identified the adverse effects of liquidity risk over the financial institutions, capital markets and economies. It will be discussing the classical contagion mechanism which is well known as "domino effect". (theory page 6) The failure of major financial institutions activated the failures in many other financial institutions that have large exposure to risks. Bassis J. (2010) has described the "domino effect" as the foundation of the "too big to fail" principal.

It's also reviewed the importance of supervision and regulations. The implementation of Basel Accords and the criticisms have also been discussed. Moreover the implementation of Supervisory Review Process under pillar II in Basel II and the measurements of capital adequacy requirements, importance of stress testing under liquidity risk management are explained.


Access of primary data






Considering the risks associated with financial institutions, it's important to have a clear definition of the term of 'risk'.

Risk can be defined as the volatility of firms' market value (Kupper E F, 1996, p22) and according to Pyle D H (1997) risk can be determined as decreasing of firm's value due to changes.

Operational Risk (People, Process, Systems and External), Financial Risk (Credit, Market, Liquidity and Insurance) and Business Risk (Strategic Management) are identified as the three main risks that associated with any financial institution (Rochette M. 2005). Moreover Market risk, Credit Risk, Operational Risk, Insurance Risk, Liquidity Risks etc are identified as Prudential Risks (Sharma P. 2004). Even though these concepts are distinct from one another, they are closely inter related in a rather complex way (Financial Stability Review. 2008).


According to Bessis J (2010) "liquidity is the capability of raising cash sufficiently for lending opportunities, meeting depositors' obligations when they want to withdraw money at a reasonable cost and within a reasonable time frame. Banks face liquidity by collecting deposits and raising finance for their customers. Liquidity risk exists when banks are not able to raise liquidity or raise liquidity at a high cost" (p 272).

According to Adrian T and Shin H S (2008) liquidity risk is a mysterious notion as it is easier to recognise than its defined. Moreover it's defined the bank liquidity risk as the ability of a bank to meet its immediate obligations. However bank liquidity risk does not arise on its own and the other liquidity risks such as market liquidity (ability to trade assets or securities in the market without affecting its prices), liquidity of financial instruments ( ability to exchange financial assets without lack of difficulty and losing its value), funding liquidity and balance sheet liquidity ( amount of liquid assets on balance sheet) are also interrelated even though these liquidity risks are distinct from each other (p 1). Therefore it's essential to analyse the relationship between bank liquidity risks and other liquidity risks and their impact towards liquidity risk management in banking. The recent crisis is one of the main examples to describe this relationship and it's been discussed under causes for liquidity risks.

Asset liquidity

Funding liquidity

Funding liquidity can be determined as the ability to settle the immediate obligations when they due. Funding liquidity risk exists when bank is illiquid and it's impossible to meet its obligations when due. Historically it has identified that funding liquidity risks has played a crucial role in banking crisis. It has been proved the recent crisis as interbank markets collapsed and central banks had to intervene into money markets in an extraordinary way.


Mismatching long term assets and short term liabilities

"Mismatch risk is initially occurred as a result of maturity of assets being often longer than maturity of financing and it creates liquidity risk when financial intermediaries roll over their short term debts. Mismatch risk is common for all deposit institutions as they utilise their short term deposits (at a lower rate) to lend long term (at a higher rate). Therefore, financial institutions should aware of such risks and it's essential to keep more highly liquid assets to avoid market deficiencies as liquidity assets are less riskier to sell without having significant losses (Bessis J. 2010, p8 ).

Since late 1990's it has been a significant increase in maturity mismatch and comparatively, long term assets such as mortgage loans and MBS have been held a significant proportion of asset side (debtors) in the banks' balance sheets. The underline problem is when banks fund long term illiquid assets with the short term liabilities that are payable on demand, and if a large proportion of depositors demand for their deposits simultaneously the bank will not be able to meet the obligation. It has prominently been shown during the recent crisis; collapse of Northern Rock UK and Bear Sterns in the US. Some researches (Diamond and Rajan 2009, p606) has observed the recent crisis as a "misallocation of resources to real estate (long term illiquid assets) and financed through the issuance of exotic new financial instruments that were largely financed with short term debts" (Hogan, Wiseman and Young 2010, p 4)

Although mismatch risk has been caused for the collapse of major financial institutions, the mismatch risk is still left to control directly to banks without requiring any capital charge. (Bessis J. 2010 P 8)


Transformation of financial markets

However when stepping back and observe the causes related to liquidity shocks, it's important to look at the transformation of financial markets over the last decade and the impact of liquidity. Banks are treated as liquidity providers; at the same time banks have become users of market liquidity. Many market participants such as hedge funds and market brokers rely on the liquidity facilities provided by banks. But banks, especially investment banks depend on securities issued for funding their financing needs. Therefore the activities in financial markets have been directly affected to banking liquidity. Moreover the fluctuations in market liquidity has directly affected to the bank's balance sheet. Most of the market participants including banks involve in hedging risks by buying and selling short term securities in the financial markets. Therefore there is a significant impact on solvency from illiquid financial markets (Adrian T and Shin H, 2008. p 2).

Inter-Bank Markets

It was significant that the inter-bank markets were dried up so fast and hardly during the time of the current financial turmoil. According to Adrian T and Shin H S (2008), it's been affected by the interaction between uncertainty and liquidity. According to Adrian T and Shin H S (2008) inter-bank markets were hardly hit as a result of fundamental uncertainty (which affects quality and value of assets) and strategic uncertainty (reactions of markets participants during specific conditions). The outcomes of these uncertainties could be led banks to hold maximum liquidity, ignoring the costs, but on the other hand it can be said that such precautions are unnecessary and costly because in the worst case scenario, banks can always access to special central bank facilities such as emergency liquidity assistance, marginal lending facilities or discount windows (Discount window is an monetary instrument that allows banks to borrow money from central banks in short term basis during the times of internal or external deficiency to meet its liquidity requirements). The recent events shown the utilisation of above facilities provided by central banks. However it can be seen there is a drawback of using the above facilities, as a fear of "signalling" effect that shows the banks difficulties to other market participants, investors and depositors (Adrian T and Shin H S, 2008 p 5).

Moreover, Adrian T and Shin H S (2008) determined that strategic behaviour of some banks in relation to imperfect competition and they lend short term liquidity in order to build up their power by weakening the competitors. Therefore it is explained a link between liquidity and competition and it can affect the hedging decisions with respect of liquidity risk ( p5).

Difference in intermediation and valuation between the old and the new world of banking

In the old banking system, banks are the only entities to undertake financial intermediation and in the new world financial intermediation takes place in the financial markets mostly by trading securities. More over the development of investment banks, mutual funds etc has increased the exposure towards liquidity risks (Adrian T and Shin 2008, p1)

Additionally in the old banking system, assets are valued at historical costs and depreciation has taken place according to pre-set rules and judgements while in the new world assets are valued and accounted at the market value or fair value (Adrian T and Shin H S, 2008 p 1). At the same time there is a correlation between liquidity and solvency through the valuation process of securitised assets and the overall market liquidity determines the value of each security. In the new system as a result of holding more assets and securities in the balance sheets and when the assets are valued their market values, fluctuation of asset prices has a immediate impact on the net value of the balance sheet. During times of stress, liquidity movements immediately translate to balance sheets and especially for equity base banks and financial intermediaries. These liquidity shocks can translate to solvency shocks as taken place during the recent crisis (Adrian T and Shin H S, 2008 p2).

Market liquidity affects all the market participants and as described before there is a significant impact on their capital base as well. It finally leads to a decrease or increase of the ability to provide liquidity. According to Adrian and Shin this contagion effect is increased when the financial institutions actively manage their balance sheets (Adrian T and Shin H S, 2008 p3)

Off balance sheet items

Adverse effects of accounting standards

The adverse effect of collateral-based leverage

Inefficient practices of Governance of banks

Compensation culture/ remuneration policy is too oriented towards profitability



Banks rely on liquidity assets during the times of market disruptions. Liquidity assets are assets such as treasury bills which value are less sensitive exposure to interest rates fluctuations and less risky assets that can be sold without reducing its value. At the same time as they are less risky they get a less return as well. Therefore holding highly liquid assets will adversely be affected to firms' profits (Bessis J. 2010 p-272).

However the recent crisis emphasized the crucial importance of liquidity to the banking industry. Moreover the decrease of liquidity in interbank markets and structured products, transfer of off balance sheet commitments to banks balance sheets, had led to a major funding liquidity pressure for some banks and intervention of central banks also seen in some cases simultaneously.


However under normal conditions liquidity management depends on liquidity gaps. Liquidity gaps are differences between the assets and liabilities of the bank portfolio at all future dates. There are three main situations can be determined: cash matching, underfunding and overfunding. (Bassis J. 2010. p 272)



It was significant the greatest collapse of US banks during 1965-1981 and it was basically defined as a savings and loan crisis. The Basel Committee of Banking Supervision has been established as a result of the potential for the bankruptcy risks due to lack of supervision in the banking industry (Curry T and S Lynn, 2001). Basel Capital Accords has been implemented in 1988 and it has been significantly focused on credit and market risks within the banking industry. However Basel accords has been criticised on several grounds and these criticisms have led to the implementation of Basel II in 2004. According to Eischengreen B. (Feb 2008) the risky off balance sheet items such as Structured Investment Vehicles (SIV) and conduits have grown as banks were encouraged by Basel II in 1988 (p 21). Moreover the creation of off balance sheet items have allowed banks to reduce its capital, associated with risk profile. At the same time the innovations in Basel II has encouraged banks to reduce transparency, excessive risk taking and weak regulatory inspection.

Associated risks in banking are interrelated to each other. Therefore it's not possible to manage liquidity risk as an individual manner and it's essential to manage them as a whole in practice. At the same time Capital Adequacy requirement play an important role in assessing risks and it's appropriate to discuss the assessment of capital adequacy requirement at the same time. Capital can be defined as, the source to cover the risks need to meet supervisory criteria. Reviewing Basel II, Supervisory Review Process is the key element in pillar II and can be described as in essential process in measuring Capital adequacy.

Supervisory review Process Under Basel II

According to Vesala J (Deputy Director General, Finnish FSA Finland), the supervisory Review Process (SREP) under Basel II has been defined as a key element of Capital adequacy framework and an important guiding framework for supervisor activities. According to the key element of SREP, it covers the main element of prudential supervision. In Europe it covers not only the banks but also the investment firms. SREP basically contains what's banks are doing themselves and the key element of the framework is to encourage banks all internal work as the banks are required to have a formal process for internal capital adequacy assessment. That covers risks and how much capital allocated to various risks. Therefore the key element is based on the banks own internal capital adequacy assessment (ICAAP). Moreover SREP is not only about quantitative aspects but it covers also qualitative aspects most importantly capital adequacy and the features of risk management process in banks.

Although it's importantly identified that the capital is not always the best or even most appropriate element mitigating of risks. On the other hand capital determines the ability to absorb losses or potential financial losses.

Vesala J also acknowledged the main objective and scope of the SREP as the pillar II of Basel II in his seminar on "effective risk based supervision; how to develop a good supervision by reviewing SREP under Basel II.

Additionally SREP is basically covers all material risks in banking books and the risks associated with the business environment. It also aims to approach the long term viability of banks and to assess the ability to cope with the fluctuations of macro-economic environment and capital markets.

SREP in Basel II covers the pillar I and pillar II risks as follows:

Pillar I

Credit risk

Market risk

Operational risk

According to SREP in addition to the pillar I risks banks have to allocate capital for the pillar II, but there is no explicit capital requirement has been designed in the regulation. It's been identified two categories of pillar II risks by SREP and they are:

The possible short comings of the pillar I risk management and capital calculation

Risks beyond the scope of pillar I

Concentration risk

Residual securitisation risk

Interest rate risks on banking books (IRRBB)

Liquidity risk

Business and Strategic risk

Discussing the risk measurement and capital allocation according to SREP, Dr Vesala J explains how banks are expected to measure and manage various risks. In Basel II, banks can use their own internal methods to calculate pillar I requirements.

Credit risk - Internal Rating Based Approaches (IRBA)

Market risk - Value at Risk method (VaR)

Operational - Internal Modelling Methods, that are called Advanced Modelling Approach (AMA)

It can be identified that Basel II has given more chance to banks to develop their own risk management methods and modelling approaches. At the same time it could be led for higher standards of risk management, capital allocation and developments in risk management modelling in banking.

Although, the banks can use their own methods to calculate pillar I requirements, those models need to be approved by the supervisors and the strict quality requirements should be met and demands on internal controls have to be proved before the approval is granted.

Moreover considering pillar II risk requirements, there are much more levy for banks, assessing potential risks. If banks are well developed, they can use their internal methods; that can be highly advanced and for less developed banks can spend less money for their internal modelling techniques. In this case supervisors play an important role making sure the internal methods used by banks are sufficient to cover the pillar 2 risks. (DRAWBACKS NEED TO BE DISCUSSED IN ANALYSIS)

More importantly, banks need to do stress tests on,

Risk in macro economics and business environment

Credit quality migration - IRB stress test

Credit risk and other risk concentration

Market risk - Equity price risks, FOREX risks, Commodity price risks

Finally Liquidity risk is an extremely important - stress testing on liquidity position of banks

According to Basel II it's also essential to describe how banks are expected to cover the various risks.

All risks need to be managed and measured adequately- (given the size and nature of bank's business and risks and addressed separately in the banks internal capital adequacy assessment approaches.

How much capital would be needed to cover each of the risks: banks are expected to hold more own funds than needed at minimum 8% of risk weighted assets. (RWA)

Vesala J (2009) also explained that some risks such as liquidity risks may not be effectively covered by capital. Therefore it's essential for banks to have adequately higher amount of liquid assets in banks balance sheets to cover liquidity risk and the same can be used when the bank run into a payment problem. The main issue is the sound risk management is never compromise with supervisors' assessments. Good risk management standards and internal controls may reduce the amount of capital buffers. (capital buffer is the excess capital that banks have over the minimum capital requirement. Capital buffer= total own funds (tier I and tier II capital) - minimum capital requirement)

Moreover, if a bank uses its own models, it should be conservative; the capital adequacy assessments needs to be sound and safe and based on well founded models. At the same time supervisors need to make sure the models are reliable and risks needed to be addressed seperately

(LIQUIDITY MANAGEMENT FRAMEWORK AND SUPERVISION) expected contribution by analysing different banks frame works and regulations




Bank for International and Settlement (BIS) is one of the main regulators that provide supervisory frame work in risk management in banking. BIS have implemented the Supervisory Review Process (SREP) under Basel 2 and it's a key element of Capital adequacy framework for guiding supervisor activities. Main objective and scope of the SREP is pillar II of the Basel II framework. It's been discussed under


According to the survey conducted by KPMG 2008 seven out of ten respondents idea was that the risk departments in banks are under the influence of strategic management. (Conover M, Harman N, Hashagen J, Sharma J, P 94)