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Liquidity Risk And Maturity Transformation In Banks Finance Essay

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Published: Mon, 5 Dec 2016

This research proposal will focus on one of the key area of risk in banking sector which is liquidity risk. There are three definitions which are commonly used for the liquidity. First one is the ease that the financial instruments can be converted in to cash. Second is market concept of the liquidity is the ability to trade the assets or securities without losing its value. The last is the monitory liquidity means the total number or total quantity of the liquid assets which are trading in the economy. (Adrian and Shin, 2008). The purpose of the literature review and dissertation is tried to address the main reasons of mismatching of assets and liabilities in banks.

LIQUIDITY RISK.

Mismanagement of liquidity can lead to bankruptcy. We cannot differentiate liquidity and solvency in bank. Some time the bank which is illiquid can be insolvent and on the other hand the bank which is insolvent can be illiquid. This is why the capital and liquidity adequacy performance is the major concern of the commercial bank. (Good Hart, 2008). Liquidity and solvency has the strong relationship. “In Banking act of 1935 liquidity and solvency practically has become the synonymous terms”. (Walter A. Morton, 1939). This is the fact that because of mismanagement of the liquidity the financial market faced some remarkable events in 2007 and 2008. Burnermair presents his view about the crisis of 2007-08. “Financial markets experienced extraordinary events in 2007 and 2008. The increase in delinquency rates of subprime mortgages, coupled with the mismatch in the maturity structures of off-balance-sheet conduits and structured investment vehicles (SIVs), led to a sudden drying up of asset-backed commercial paper and the failure of several banks, including a classic bank run in the United Kingdom. The eruptions in credit and money markets ultimately led to a run on one of the leading investment banks in the United States”. (Brunnermeier, 2008). The liquidity cans effects in two ways or it has the two ways impact on the bank. One side is high liquidity ratio send a positive signal to the depositors. This shows that the bank is liquid and it increase the confidence of the depositor and the lower level of the liquidity means the bank is not in strong liquid position and will unable to pay its commitment. But if we see the other side high liquidity shows the inefficient use of the resources. This shows bank will not efficient in investment activities and will lose the profitability. (Gunsel, 2010).

This is very broad topic even the word liquidity has many definitions. As Good Hart says in one of his article “Unfortunately the word ‘liquidity’ has so many facets that it is often counter-productive to use it without further and closer definition”.(Good Hart, 2008).

MATURITY TRANSFORMATION.

The key face or side of liquidity which we are going to cover in this research is the maturity transformation which means that the maturity of assets and liabilities in balance sheet of bank. In normal practice bank perform a valuable activity on either side of the balance sheet. On asset side they go for long term investments or make long term loan. They make loan for illiquid borrowers because they want flow of capital in economy. On liabilities side they need liquidity on demand to depositors. There is incompatibility between these two activities. Demand for the liquidity can arise at inconvenient time and can put the banks in trouble. Other activities of the banks can be affected. This is why an army of the regulators always supervise the bank to protect them from their own fragility. (Douglas, 2001).

Bank activities are link with all economy and failure of one bank can create a multiplier effect. One of the main or most important reasons for the crisis in financial sector is the failure of the bank because bank failure starts systemic risk. (Douglas W Diamond, 2005). This is why the regulation regarding liquidity and capital requirement has become too much important.

REGULATIONS FOR THE LIQUIDITY.

There are three main reasons for the regulation of liquidity management. According to Adrian and Shin. “First, pure market failures. There are no incentives for banks to hold adequate amounts of liquid assets because: (1) liquidity is costly, especially when competition drives the search for higher returns on equity; (2) liquidity shortages are very low probability events; (3) there is a perception that central banks will step in and provide liquidity support if and when it is needed (the moral hazard argument).Second, liquidity requirements can be seen as a way of sharing the cost of the “public good” of liquidity and financial stability between the private and the public sectors. This would help and mitigate moral hazard; it would also compensate for other implicit subsidies, such as deposit insurance, granted to the banking sector. Finally, stronger liquidity requirements would reduce the strategic uncertainty affecting banks actions, since they would be able to withstand larger shocks”. (Adrian and Shin, 2008).

Basel committee is working since 1980 to take measures the issue of liquidity in bank. The concern of this committee is to decide what should be the capital adequacy ratio. This mean what should be the minimum level of capital that financial institutions must have to keep. There should be the prior standard regarding to maturity transformation. According to author the standard for the maturity transformation has not been maintained. The proportionate is going to be increased for financing long term assets with short term borrowings. In this aspect what bank do “they Conduits financing tranches of securitised mortgages on the basis of three month asset backed commercial paper”. An example of this is Northern rock. The important thing which come in our mind who should be responsible to take in to consideration the issue of maturity transformation whether it should be central bank or bank itself. For the case of maturity transformation how long the bank will able to fulfil its commitments just in case the markets on which it relies suddenly dry up. . (Good Hart, 2008).

MISMATCHING OF MATURITIES.

It has been seen since many years that maturity mismatches in the balance sheet of the bank can lead to liquidity crisis. It was one of the reasons of the East Asian crisis in 1998. (Rajan and Bird, 2001). This is one of the reasons that maturity mismatch and the risk associated in doing this have got the considerable attention in markets. In bank its important is central because banks are in the business of maturity transformation. They take assets and usually repaid on short notice and use these deposits to provide credit facilities to borrower for long period. In simple banks need liquidity to meet the depositor demand or with drawls, to settle whole sale commitment, to provide funds when borrowers draw on committed credit facilities. Under stress condition maturity transformation is quite crucial. Because in crisis it is difficult to raise liquidity from different sources. (Financial supervision commission, 2005). This mean banks need to manage the liquidity but from the above point of view banks can manage liquidity to give short term loans because banks borrow for short term but this is not so easy.

REASONS FOR MISMATCHING MATURITIES IN BANKS.

Hendrik explained if the banks go for liquidity preference they will give the short term loans but on the other hand borrowers demand long term loans because they want steady source of debt capital. (Hendrik, 2006). In the same paper Hendrik argued that “Economic theory postulates that financial institutions are exposed to a significant interest rate risk which is largely due to their engagement in maturity transformation”. Banks set loans on the basis of some standards.

Borrowers with low credit ratings bank gives them short term loans and borrowers having high credit rating bank gives long term loan. (Douglas, 1991). So credit rating of borrower is quite considered in maturity transformation.

Some time attitude of the managers who are in decision making is really matter in maturity transformation. This phenomena regarding risk is explained by James. He said “the idea of risk is embedded, of course, the larger idea of the choice as affected by the expected return of an alternative. Virtually all the theories of the choices assume that decision maker prefer larger expected returns to smaller one provided the other entire factors constant (risk)”. (Lindley, 1971).

In general they also assume that decision maker prefer smaller risk to larger one, provided other factors (expected value) are constant. (Arrow, 1965). Thus the expected value is assumed to be positively associated, and risk is assumed to be negatively associated with the attractiveness of an alternative.” (James, 1987). So above argument shows manager risk taking or risk seeking attitude can effect maturity transformation decision.

In normal practice during maturity transformation banks prefer high interest or high profit. They mismatch their liabilities and assets means borrow for short term and lend for long term. This practice leads to liquidity risk. This practice of mismatching of assets and liabilities in balance sheets of banks is continued since many years and is the main reason of the liquidity crisis. This mismatching of liabilities and assets has the significant part in East Asia crisis 1997-1998. Bank pays insufficient attention to maturity transformation because they prefer high risk and high return. This self interest behaviour leads to liquidity crisis. “It is to reconfirm that liquidity crises can occur in the absence of bail out provisions and can result simply from maturity mismatches that themselves reflect the outcome of self-interested optimising behaviour by commercial banks”. (Rajan and Bird, 2001). Bank capital structure also influence on maturity transformation. Some bank have excess capital this mean their capital to asset ratio is good. So this thing also affects the lending behaviour of the bank. By considering their capital structure they take the risk and mismatch the maturities of assets and liabilities. (Gambacorta and Mistrulli, 2003).

From the above paragraph the different views of the authors come in front regarding reasons for the mismatching of the maturities. Following important reasons have been indicated. Borrowers demand for the long term loan, credit rating of the borrowers, risk taking behaviour, high profitability and bank’s capital structure.

MATURITY TRANSFORMATION STRATEGIES BY THE FINANCIAL INSTITUTIONS.

Most of investors prefer the loan having short maturity or terms. “Now the commercial banks have created the off-balance sheet vehicle that converted or shorten the maturities of the long term products. Investment banks now rely on overnight repo markets to finance their balance sheet. So the question is what these off- balance sheet vehicles are. Off balance sheet vehicles are the structured investment vehicle. This means invest in long term illiquid assets and issue short term maturity paper in the form of asset backed commercial paper which have an average maturity of 90days and medium term notes which having the average maturity of one year. Asset backed commercial paper was very popular in 2006. The off-balance sheet vehicles’ strategy of investing in long-term assets and borrowing using short-term paper exposes them to funding liquidity risk, since the commercial paper market might suddenly dry up. To ensure funding liquidity, the sponsoring bank grants a credit line, or a so-called liquidity backstop.3 Thus, the banking system still bears the liquidity risk from the maturity transformation-like in the traditional banking model of banks, in which commercial banks take on short-term deposits and invest in long-term projects”. (Brunnermeier, 2008). While transforming the maturities the banks or financial institutions has to see the concern of the investors. Investors are concerned with return which they can obtain on short notice. Because they are uncertain about the need of the funds. So the activities of the bank to provide the liquid investment opportunity. Banks do this through two channels. First bank deposits offer an option to obtain funds on short notice at lower opportunity cost as compare to market. (James, 1987).

IMPORTANT OF LIQUIDITY W.R.T MATURITY TRANSFORMATION.

Above views of the author’s shows that how important is the management of liquidity in banks. No doubt it is important in banking sector because of different reasons but this not means that other sectors not face liquidity risk. All sectors combine to make economy and failure of one sector will affect overall economy of country. Holmstrom has explained in his article that management of liquidity for both real and financial sector is important. If both sector will manage their liquidity need, will be better able to run their operations efficiently and effectively without facing liquidity shortages. (Holmstrom, 2000). Liquidity risk management is important because liquidity shortfall affect the whole system and effect the overall economy. (Basel Committee on Banking Supervision, 2008).

CONCLUSION.

We have discussed the liquidity which means the ease that the financial assets can be converted into cash. Liquidity is very important and mismanagement of the liquidity can lead to bankruptcy. Banks can be insolvent because of the liquidity mismanagement. This is the reason that capital adequacy ratio has the greater concern for the regulatory bodies. Basel committee is working since 1988 to overcome the issue of capital adequacy. Because the stability of the financial institution is the concern of overall economy. In banks how they transfer their maturities means assets and liabilities in balance sheet of banks so that to avoid liquidity risk. Because the reason for the financial crisis in past this maturity mismatching structure of the banks. They finance long term loans with short term borrowings and when the time come to fulfil their commitments they are unable to generate liquidity. Why these institutions go for this mismatching structure because there are different reasons borrowers demand for the long term loan, credit rating of the borrowers, risk taking behaviour, high profitability and bank’s capital structure. So the financial institutions must have the proper strategies regarding liquidity.

BIBLOGRAPHY.

Tobias Adrian and hyun song shin. (2008). Liquidity and financial contagion. Financial stability review-special issue of liquidity. No.11. Feb. 2008.

Charles Good hart. (2008). liquidity risk management. Financial stability review-special issue of liquidity. No.11. Feb. 2008.

Markus K. Brunnermeier. (2008). Deciphering the 2007-08 Liquidity and Credit Crunch

Nil Gunsel. (2010). The deteminants of the bank failure in north cyprus. Journal of the risk finance, vol 11, NO . 1.

Douglas W. Diamond and Raghuram G. Rajan. (2005) Liquidity Shortages and Banking Crises. The Journal of Finance, Vol. 60, No. 2 (Apr., 2005), pp. 615-647

Walter A. Morton. (1939). Liquidity and Solvency. The American Economic Review, Vol. 29, No. 2 (Jun., 1939), pp. 272-285

Hendrik Schulz, Stephen Simon, Marko Wilkins. (2006). Maturity Transformation Strategies and Interest Rate Risk of Financial Institutions: Evidence from the German Market. Oct 2006.

Ramkishen S. Rajan and Graham Bird. (2001). Banks, Maturity Mismatches and Liquidity Crises: A Simple Model

Leonardo Gambacorta and Paolo Emilio Mistrulli. (2003). Does bank capital affect lending behavior?

Bengt Holmstrom and Jean Tirole, 2000). Liquidity risk management. Journal of money, credit and banking, Vol. 32, No. 3 (Aug., 2000).

Financial supervision commission, 31 January 2005. A Consultative Paper on Liquidity Risk Management Policies for Banks.

Douglas W. Diamond. (1991). Debt Maturity Structure and Liquidity Risk. The Quarterly Journal of Economics, Vol. 106, No. 3 (Aug., 1991), pp. 709-737

James G. March and Zur Shapira, (1987). Managerial Perspectives on Risk and Risk Taking Management Science, Vol. 33, No. 11 (Nov., 1987), pp. 1404-1418

Basel Committee on Banking Supervision, June 2008. Principles for sound liquidity risk management and supervision.

Paul Sharma, 8 October 2004. Financial services authority speech.


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