LIQUIDITY RISK MANAGEMENT

Liquidity risk management is the process of ensuring that a company or institution has
enough cash to meet its financial obligations. It's a critical component of financial
performance and can have severe consequences if not managed properly. Liquidity risk
management defined as the ability to meet cash flow and collateral needs (under
normal and stressed conditions) without negatively affecting day-to-day operations,
overall financial position or public sentiment.

Liquidity Risk Management (LRM) is a crucial aspect of financial risk

management that involves ensuring that an organization particularly
financial institutions like banks has sufficient liquidity to meet its short-term
and long-term obligations. It aims to avoid liquidity shortfalls that could lead
to operational disruptions, financial distress or even insolvency.

The objective of effective liquidity management is to ensure that firms can meet their
contractual obligations and other cash commitments efficiently under both normal
operating conditions and under periods of market stress. To help achieve this objective,
Boards must establish liquidity guidelines that require sufficient asset-based liquidity to
cover potential funding requirements, and to avoid over-dependence on volatile, less
reliable funding markets.

According to the Basel Committee, during the early “liquidity phase” of the financial
crisis that began in 2007, many banks – despite adequate capital levels – still
experienced difficulties because they did not manage their liquidity in a prudent manner.

The crisis again drove home the importance of liquidity to the proper functioning of
financial markets and the banking sector. Prior to the crisis, asset markets were buoyant
and funding was readily available at low cost. The rapid reversal in market conditions
illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended
period of time.

The banking system came under severe stress, which necessitated central bank action
to support both the functioning of money markets and, in some cases, individual
institutions. The difficulties experienced by some banks were due to lapses in basic
principles of liquidity risk management. In response, as the foundation of its liquidity
framework, the Committee in 2008 published Principles for Sound Liquidity Risk
Management and Supervision (“Sound Principles”).

The Sound Principles provide detailed guidance on the risk management and
supervision of funding liquidity risk and should help promote better risk management in
this critical area, but only if there is full implementation by banks and supervisors. As
 such, the Committee will coordinate rigorous follow up by supervisors to ensure that
banks adhere to these fundamental principles.

To complement these principles, the Committee has further strengthened its liquidity
framework by developing two minimum standards for funding liquidity.

These standards have been developed to achieve two separate but

complementary objectives

The first objective is to promote short-term resilience of a bank’s liquidity risk profile by
ensuring that it has sufficient high-quality liquid assets to survive a significant stress
scenario lasting for one month. The Committee developed the Liquidity Coverage Ratio
(LCR) to achieve this objective.

The second objective is to promote resilience over a longer time horizon by creating
additional incentives for banks to fund their activities with more stable sources of
funding on an ongoing basis. The Net Stable Funding Ratio (NSFR) has a time horizon
of one year and has been developed to provide a sustainable maturity structure of
assets and liabilities.

These two standards are comprised mainly of specific parameters which are
internationally “harmonised” with prescribed values. Certain parameters, however,
contain elements of national discretion to reflect jurisdiction-specific conditions. In these
cases, the parameters should be transparent and clearly outlined in the regulations of
each jurisdiction to provide clarity both within the jurisdiction and internationally.

It should be stressed that the standards establish minimum levels of liquidity for
internationally active banks. Banks are expected to meet these standards as well as
adhere to the Sound Principles. Consistent with the Committee’s capital adequacy
standards, national authorities are free to require higher minimum levels of liquidity.

 Understanding Liquidity Risk in Banks and Business

Liquidity risk management is critical to ensuring that cash needs are continuously met.
Common ways to manage liquidity risk inclu...

Liquidity is a bank's ability to meet its cash and collateral obligations without sustaining
unacceptable losses. Liquidity risk refers to how a bank’s inability to meet its
obligations (whether real or perceived) threatens its financial position or existence.
Institutions manage their liquidity risk through effective asset liability management
(ALM).
 During the recent prolonged period of historically low and stable interest rates, financial
institutions of all shapes and sizes took liquidity and balance sheet management for
granted. But as rates rose and uncertainty increased, many institutions struggled to
maintain adequate liquidity and appropriate balance sheet structure due to deposit run-
offs and portfolio duration mismatches.

Liquidity risk was exacerbated by asset value deterioration while monetary policy
tightened. Inadequate balance sheet management led to highly publicised bank failures
and a heightened awareness of liquidity risks.

In the wake of these bank failures, one thing became clear: banks and capital markets
firms need to manage their liquidity and balance sheets better. And self-preservation
isn’t the only motive for doing so. The consequences of poor asset liability management
and liquidity risk management can reach far beyond the walls of any one financial
institution. It can create a contagion effect on the entire financial ecosystem and even
the global economy.

Regulatory bodies are intent on preventing another financial crisis in the future, and
scrutiny of liquidity management is increasing. The onus is now on financial institutions
to shore up liquidity risk and balance sheet management – for the good of the firm and
the economy.

Liquidity risk management defined

Liquidity risk management and ALM encompass the processes and strategies a bank
uses to:

 Ensure a balance sheet earns a desired net interest margin without exposing the
institution to undue risks from interest rate volatility, credit risk, prepayment dynamics
and deposit run-off.

 Plan and structure a balance sheet with a proper mix of assets and liabilities to optimise
the risk/return profile of the institution going forward.

 Assess its ability to meet cash flow and collateral needs (under normal and stressed
conditions) without negatively affecting day-to-day operations, overall financial position
or public sentiment.
 Mitigate risk by developing strategies and taking appropriate actions to ensure that
necessary funds and collateral are available when needed.

The role of balance sheet management

Balance sheet management, through strategic ALM, is the process of managing and
optimising assets, liabilities and cash flows to meet current and future obligations.
Effective ALM not only protects financial institutions against the risks of falling net
interest margins and funding crunches – it's also an opportunity to enhance value by
optimising reward versus risk.

Good asset liability management broadly covers portfolio accounting, analytics and
optimisation. It relies on a suite of tools for transaction capture, forecasting, interest rate
risk measurement, stress testing, liquidity modelling and behavioural analytics.

Challenges to successful balance sheet management

 No centralised view of balance sheet management. Siloed departments and

business units limit a firm’s ability to understand its balance sheet positions (especially
those involving optionality and customer behaviour). Silos also make it challenging to
assess the impact of illiquid assets across geographies, business units and asset
classes.

 Limited analytics capabilities. Without sufficient analytics, firms have extreme

difficulty projecting cash flows and net interest margins for underlying transactions,
particularly when those transactions number in the millions. Overly simplified term
structure and behavioural models lead to limited balance sheet risk management.

 Insufficient stress testing. Because too many firms have commonly ignored trading
and funding liquidity considerations in stress testing, they are unprepared for the
impacts of market shocks, making it hard for them to get out of positions easily or to
attract new funding.

 Overcoming the compliance mindset. Firms that focus too much on the compliance
requirements surrounding balance sheet management may overlook potential business
benefits.

LIQUIDITY RISK MANAGEMENT

 Maintain liquid assets: Keep a portfolio of high-quality liquid assets that can be easily
exchanged for cash
 Forecast cash flow: Use rigorous cash flow forecasting to anticipate cash needs
 Diversify funding sources: Have a variety of funding sources to reduce risk
 Comply with regulations: Follow regulatory frameworks that establish minimum
liquidity standards
 Conduct stress tests: Assess liquidity risk by simulating different scenarios to see how
the institution would perform
 Plan for contingencies: Have a plan in place to deal with unexpected events
 Analyze risk: Establish a framework for calculating risk and analyzing its effects
 Manage data: Keep up to date with market information and views on liquidity risk
Liquidity risk can manifest in two forms: market liquidity risk and funding liquidity
risk. These two types of risk are often connected and can make each other worse. For
example, if a company can't secure short-term funding, it might have to sell assets at a
loss, which could further weaken its financial position.

3 steps to successful liquidity risk management and ALM

To institute an effective liquidity risk management and ALM system at your organisation,
follow these three steps.

1. Establish an analytic framework for calculating risk, optimising capital and measuring
market events and liquidity.

 Minimise the effects of market shocks and look for better risk management opportunities
by analysing the consequences of changes in cost and liquidity in near-real time. Then
you can act with precision.

 Analyse cash flow and market value dynamics comprehensively and granularly.
Proactively manage your assets and liabilities with on-demand scenario analysis
incorporating forward-looking market condition and balance sheet evolution
assumptions.

2. Manage your data.

 Gain a centralised view of firmwide interest rate and liquidity risks by integrating the
latest market information, portfolio updates, capital returns and a market view of liquidity
on an intraday scenario basis.
 3. Integrate your risk management processes.

 Value complex portfolios and asset classes using an efficient platform to integrate
portfolio valuation and scenario analyses with consistent market, credit and behavioural
models. Process orchestration and governance can further reduce operational risk.

Liquidity Risk
 Liquidity risk is the risk that the Bank is unable to meet its financial obligations in
a timely manner at reasonable prices. Financial obligations include liabilities to
depositors, payments due under derivative contracts, settlement of securities
borrowing and repurchase transactions, and lending and investment
commitments.
 Effective liquidity risk management is essential to maintain the confidence of
depositors and counterparties, manage the Bank’s cost of funds and to support
core business activities, even under adverse circumstances.
 Liquidity risk is managed within the framework of policies and limits that are
approved by the Board of Directors. The Board receives reports on risk
exposures and performance against approved limits. The Asset-Liability
Committee (ALCO) provides senior management oversight of liquidity risk.
The key elements of the liquidity risk framework
 • Measurement and modeling – the Bank’s liquidity model measures and
forecasts cash inflows and outflows, including off-balance sheet cash flows on a
daily basis. Risk is managed by a set of key limits over the maximum net cash
outflow by currency over specified short-term horizons (cash gaps), a minimum
level of core liquidity, and liquidity stress tests.
 • Reporting – Global Risk Management provides independent oversight of all
significant liquidity risks, supporting the ALCO with analysis, risk measurement,
stress testing, monitoring and reporting.
 • Stress testing – the Bank performs liquidity stress testing on a regular basis, to
evaluate the effect of both industry-wide and Bank-specific disruptions on the
Bank’s liquidity position. Liquidity stress testing has many purposes including:
 – Helping the Bank understand the potential behavior of various on-balance
sheet and off-balance sheet positions in circumstances of stress; and
 – Based on this knowledge, facilitating the development of risk mitigation and
contingency plans. The Bank’s liquidity stress tests consider the effect of
changes in funding assumptions, depositor behavior and the market value of
liquid assets. The Bank performs industry standard stress tests, the results of
which are reviewed at senior levels of the organization and are considered in
making liquidity management decisions.
 • Contingency planning – the Bank maintains a liquidity contingency plan that
specifies an approach for analyzing and responding to actual and potential
liquidity events. The plan outlines an appropriate governance structure for the
management and monitoring of liquidity events, processes for effective internal
and external communication, and identifies potential counter measures to be
considered at various stages of an event. A contingency plan is maintained both
at the parent-level as well as for major subsidiaries.
 • Funding diversification – the Bank actively manages the diversification of its
deposit liabilities by source, type of depositor, instrument, term and geography.
 • Core liquidity – the Bank maintains a pool of highly liquid, unencumbered
assets that can be readily sold or pledged to secure borrowings under stressed
market conditions or due to Bank-specific events. The Bank also maintains liquid
assets to support its intra-day settlement obligations in payment, depository and
clearing systems.
 Liquid assets
 Liquid assets are a key component of liquidity management and the Bank holds
these types of assets in sufficient quantity to meet potential needs for liquidity
management.
 Liquid assets can be used to generate cash either through sale, repurchase
transactions or other transactions where these assets can be used as collateral
to generate cash, or by allowing the asset to mature.
 Liquid assets include deposits at central banks, deposits with financial
institutions, call and other short-term loans, marketable securities, precious
metals and securities received as collateral from securities financing and
derivative transactions. Liquid assets do not include borrowing capacity from
central bank facilities.
 Marketable securities are securities traded in active markets, which can be
converted to cash within a timeframe that is in accordance with the Bank’s
liquidity management framework. Assets are assessed considering a number of
factors, including the expected time it would take to convert them to cash.
 Marketable securities included in liquid assets are comprised of securities
specifically held as a liquidity buffer or for asset liability management purposes;
trading securities, which are primarily held by Global Banking and Markets; and
collateral received for securities financing and derivative transactions.


 Liquidity Risk, important parts from the 2021 Annual Report, Lloyds
Banking Group plc
 Liquidity risk is defined as the risk that the Group has insufficient financial
resources to meet its commitments as they fall due, or can only secure them at
excessive cost.
 Liquidity risk is managed through a series of measures, tests and reports that are
primarily based on contractual maturity.
 The Group carries out monthly stress testing of its liquidity position against a
range of scenarios. The Group’s liquidity risk appetite is also calibrated against a
number of stressed liquidity metrics.

FUNDING AND LIQUIDITY RISK

 DEFINITION
 Funding risk is defined as the risk that the Group does not have sufficiently stable
and diverse sources of funding or the funding structure is inefficient. Liquidity risk
is defined as the risk that the Group has insufficient financial resources to meet
its commitments as they fall due, or can only secure them at excessive cost.
EXPOSURE
 Liquidity exposure represents the potential stressed outflows in any future period
less expected inflows. The Group considers liquidity exposure from both an
internal and a regulatory perspective.
MEASUREMENT
 Liquidity risk is managed through a series of measures, tests and reports that are
primarily based on contractual maturities with behavioural overlays as
appropriate. Note 51 on page F-121 sets out an analysis of assets and liabilities
by relevant maturity grouping. The Group undertakes quantitative and qualitative
analysis of the behavioural aspects of its assets and liabilities in order to reflect
their expected behaviour.
MITIGATION
 The Group manages and monitors liquidity risks and ensures that liquidity risk
management systems and arrangements are adequate with regard to the internal
risk appetite, Group strategy and regulatory requirements. Liquidity policies and
procedures are subject to independent internal oversight by Risk. Overseas
branches and subsidiaries of the Group may also be required to meet the liquidity
requirements of the entity’s domestic country.
 Management of liquidity requirements is performed by the overseas branch or
subsidiary in line with Group policy. Liquidity risk of the Insurance business is
actively managed and monitored within the Insurance business. The Group plans
funding requirements over its planning period, combining business as usual and
stressed conditions.
 The Group manages its liquidity position both with regard to its internal risk
appetite and the Liquidity Coverage Ratio (LCR) as required by the PRA, the
Capital Requirements Directive (CRD IV) and the Capital Requirements
Regulation (CRR) liquidity requirements. The Group’s funding and liquidity
position is underpinned by its significant customer deposit base, and is supported
by strong relationships across customer segments.
 The Group has consistently observed that in aggregate the retail deposit base
provides a stable source of funding. Funding concentration by counterparty,
currency and tenor is monitored on an ongoing basis and where concentrations
do exist, these are managed as part of the planning process and limited by the
internal funding and liquidity risk monitoring framework, with analysis regularly
provided to senior management.
 To assist in managing the balance sheet, the Group operates a Liquidity Transfer
Pricing (LTP) process which: allocates relevant interest expenses from the centre
to the Group’s banking businesses within the internal management accounts;
helps drive the correct inputs to customer pricing; and is consistent with
regulatory requirements. LTP makes extensive use of behavioural maturity
profiles, taking account of expected customer loan prepayments and stability of
customer deposits, modelled on historic data.
 The Group can monetise liquid assets quickly, either through the repurchase
agreements (repo) market or through outright sale. In addition, the Group has
pre-positioned a substantial amount of assets at the Bank of England’s Discount
Window Facility which can be used to access additional liquidity in a time of
stress. The Group considers diversification across geography, currency, markets
and tenor when assessing appropriate holdings of liquid assets. The Group’s
liquid asset buffer is available for deployment at immediate notice, subject to
complying with regulatory requirements.
 Liquidity risk within the Insurance business may result from: the inability to sell
financial assets quickly at their fair values; an insurance liability falling due for
payment earlier than expected; the inability to generate cash inflows as
anticipated; an unexpected large operational event; or from a general insurance
catastrophe, for example, a significant weather event. Liquidity risk is actively
managed and monitored within the Insurance business to ensure that it remains
within approved risk appetite, so that even under stress conditions, there is
sufficient liquidity to meet obligations.
 MONITORING
 Daily monitoring and control processes are in place to address internal and
regulatory liquidity requirements. The Group monitors a range of market and
internal early warning indicators on a daily basis for early signs of liquidity risk in
the market or specific to the Group.
 This captures regulatory metrics as well as metrics the Group considers relevant
for its liquidity profile. These are a mixture of quantitative and qualitative
measures, including: daily variation of customer balances; changes in maturity
profiles; funding concentrations; changes in LCR outflows; credit default swap
(CDS) spreads; and basis risks.
 The Group carries out internal stress testing of its liquidity and potential cash flow
mismatch position over both short (up to one month) and longer-term horizons
 against a range of scenarios forming an important part of the internal risk
appetite. The scenarios and assumptions are reviewed at least annually to
ensure that they continue to be relevant to the nature of the business, including
reflecting emerging horizon risks to the Group.
 The Group maintains a Contingency Funding Framework as part of the wider
Recovery Plan which is designed to identify emerging liquidity concerns at an
early stage, so that mitigating actions can be taken to avoid a more serious crisis
developing. Contingency Funding Plan invocation and escalation processes are
based on analysis of five major quantitative and qualitative components,
comprising assessment of: early warning indicators; prudential and regulatory
liquidity risk limits and triggers; stress testing results; event and systemic
indicators; and market intelligence.

Liquidity Risk Management Tools and

Techniques

Financial institutions use various tools and techniques to

manage liquidity risk:

a) Liquidity Ratios

 Liquidity Coverage Ratio (LCR): Ensures that a

bank holds enough high-quality liquid assets to cover
potential net cash outflows over a 30-day stress
period.

 Net Stable Funding Ratio (NSFR): Requires

institutions to maintain stable funding sources to
cover long-term assets.

b) Stress Testing and Scenario Analysis

Regular stress testing is conducted to assess how an

institution would perform under adverse conditions. These
tests simulate different liquidity stress scenarios (e.g., market
crises, sudden deposit withdrawals) and gauge the
institution’s resilience.
c) Cash Flow Forecasting

Forecasting future cash flows helps institutions anticipate

their liquidity needs over short and long time horizons. This
allows for proactive management of liquidity, adjusting
funding strategies based on expected inflows and outflows.

d) Contingency Funding Plans (CFP)

These are pre-determined strategies that outline how an

institution will manage liquidity during a crisis. It may involve
emergency borrowing, selling assets, or tapping into central
bank facilities.

e) Diversification of Funding Sources

Diversifying funding sources such as using wholesale

markets, retail deposits, or issuing bonds helps reduce
dependence on any single source of funding. If one source
dries up, the institution has alternatives to rely on.

Challenges in Liquidity Risk Management

Despite the importance of liquidity risk management, it

comes with several challenges which include the following:

 Unpredictability of Market Behavior: Market

disruptions, like the 2008 crisis, can be difficult to
predict, making liquidity planning challenging.

 Cost of Holding Liquidity: Maintaining a large

buffer of liquid assets can reduce profitability since
liquid assets tend to yield lower returns.

 Complexity of Global Operations: For

multinational institutions, managing liquidity across
 different jurisdictions, currencies, and regulatory
environments adds complexity to LRM processes.

CREDIT RISK MANAGEMENT

Credit management is a process in which a company or financial institution sells product/service
or lends money to customer on Credit basis, the terms it’s granted on and recovering this credit
when it’s due. The company or financial institution collects or retrieves payments from customer
or borrower at a later time, after the sale of product/service.
 There are many definitions that have been proposed to describe the institution of credit. Among
these we find:

• Credit is the ability of an individual or business enterprise to obtain economic value on faith, in
return for an expected payment of economic value in the future. (Christie and Bracuti, 1986)

• Credit is a medium of exchange with limited acceptance. After a period of time, the value
initially received by the buyer is returned to the seller in the form of payments. (Cole and
Mishler, 1995).

• Credit is a privilege granted by a creditor to a customer to defer the payment of a debt, to incur
debt and defer its payment, or to purchase goods and services and defer payment. (ICA, 2003).

Role of Credit in the Economy

Today, our economy thrives on the existence of credit. Cole and Mishler in 1995 writes: “The
use of credit has become an important part of any economy. It is the oil that lubricates economic
machinery.” Jurinski adds: “The availability of credit is the lifeblood of any nation economy….
(And) it is hard to imagine an economy without the availability of credit. Credit grows the
economy, cash retards. However, misuse, abuse or mismanagement of credit seriously debilitates
the economy. Therefore, the one to whom credit is to be extended should have the ability,
character, and willingness to comply with the terms of the credit.

According to Summers and Wilson: “Credit is pervasive in all the economies of the world
affecting financial transactions at all levels from individual consumer to multinational company.

 What We Analyse in Credit Analysis

What is Credit Analysis in the first instance?

It’s the method by which one calculates the creditworthiness of a business organization or
individual. In other words, it is the evaluation of the ability of a company or individual to honour
financial obligations.

To achieve this definition, searchlights are beamed on:

1. Analyzing audited account of a company: The objective is to determine how prudent or

otherwise the company spends, saves or invests the money it made during the immediate past
three years. The mindset for this is to know whether or not the company is capable of honoring
its payment obligations in the event of any creditline extended to it.

2. Analyzing the board of directors of a company: You analyze the make up of the board with
a view to determining their individual stake and commitment to the company, discovering their
individual advantage or disadvantage in terms of contacts that he or she have in the industry,
market or government places that the director is most likely going to bring to the company, if
need be, as well as the overall reputation of each board member for the purpose of safeguarding
the future of the company, or if a board member has a history of being critical of government
(federal, state, local) policies and the likelihood that such posture may attract attack on the
company directly or indirectly, among others.

3. Analyzing the management of a company: This is to determine their fitness to manage the
company for profit, their ability to manage the company with all sense of ethicality and
professionalism, their previous track records of a successful management of an enterprise, their
individual qualifications and experiences. The analysis shows either the management of the
company is good enough to deliver to the expectation of owners of the company, so that it can
honour its obligations to its suppliers or those with whom it does business.

4. Analyzing political environment of the country: This is to determine how susceptible or

vulnerable the company’s business might be, to determine if the line of business of the company
may expose the company to certain political attack, or the company is located in a place or
certain community where the possibility of political attack is high against the company, or in the
sudden event of government’s shift in policies, among others.

5. Analyzing the industry and market: This is where the company does its business with a
view to determining the leading and weak competitors, strong and weak products in the market
and the top five in the industry, as well as how others are doing, among others.

6. Analyzing the banking transaction: Records of the company’s banking transactions have to
be analyzed to see if the company have a case or unfulfilled credit obligations with any bank or
its name has been reported to credit bureau in relation to credit abuse or credit default.