LV Thạc sĩ_Liquidity risk management at tienphong bank

SOLVAY-BRUSSELS SCHOOL OF
ECONOMICS AND MANAGEMENT

NATIONAL ECONOMICS UNIVERSITY

Vietnam – Belgium Master Programmes
MASTERS IN BUSINESS MANAGEMENT

THESIS
LIQUIDITY RISK MANAGEMET AT TIENPHONG
COMMERCIAL JOINT STOCK BANK (TIENPHONGBANK)

Hanoi, January 2010


ACKNOWLEDGEMENT

I would like to thank all those kind people who advised or helped my thesis
research and would like to acknowledge their contributions.
First of all, I would like to express my profound gratitude to PhD, my professor supervisor for his time, advice and valuable comments. This thesis would not
have been finished without his guidance, discussion, and encouragements.
It has been an extremely valuable experience to study and work under his
supervision.
Secondly, I also thank to MBM Program for their useful guidance on academic
writing methods and resource links, as well as their deep understanding to
approve this exceptional case of a co-thesis. They all gave me the honor of
attaining such a great program.
Finally, I also want to show my deep gratitude to my families and my classmates
for their unconditional loves and their spiritual encouragement.

Hanoi, January 2010.

TABLE OF CONTENT
ACKNOWLEDGEMENT
TABLE OF CONTENT
TABLE OF FIGURES
LIST OF TABLES AND LIST OF ANNEXES
ABBREVIATIONS
EXECUTIVE SUMMARY
INTRODUCTION............................................................................................................................1
CHAPTER I: LITERATURE REVIEW..................................................................................5

I.1. Banking Risks..............................................................................5
I.1.1 Main types of risk in the banking service..................................5
I.1.2. Liquidity risk.............................................................................7
I.2. Risk management.................................................................................................................8

I.2.1. Role of risk management in banking activities........................8
I.3. Liquidity risk management...............................................................................................11

I.3.1. International liquidity risk management structure.................11
I.3.2. Framework for measuring and monitoring net funding
requirement........................................................................................12
I.3.3. Local laws and regulations relevant to risk management......19
CHAPTER II: LIQUIDITY RISK MANAGEMENT AT TIENPHONGBANK................23
II.1. Overview of Tienphongbank............................................................................................23

II.1.1. Introduction...........................................................................23
II.1.2 Strategy.................................................................................24
II.1.3 Competition...........................................................................25

II.1.4 Organizational structure........................................................26
II.1.5 Business Segments................................................................27
II.1.6. Performance from June 2008-September 2009.....................29
II.2. Liquidity risk management at Tienphongbank..............................................................31

II.2.1. Organization structure in liquidity risk management............31
II.2.2. Policy.....................................................................................32
II.3. Liquidity Measurement....................................................................................................35

II.3.1. Liquidity gap analysis............................................................35
i


II.3.2. Liquidity ratios......................................................................38

ii


II.3.3 Concentration level or larger fund provide............................39
II.3.4. Funding Structure..................................................................41
II.4. The problems of the liquidity risk management at Tienphongbank.............................43

II.4.1. Liquidity position...................................................................43
II.4.2. Problems in Liquidity risk management................................44
CHAPTER III: RECOMMENDATIONS TO IMPROVE LIQUIDITY RISK
MANAGEMENT......................................................................................................................46
AT TIENPHONGBANK..........................................................................................................46
III.1. Strengthening the liquidity risk structure.....................................................................46

III.1.1. Improve the awareness........................................................46

III.1.2. Strengthening the governance structure.............................46
III.2 Building Liquidity Standard...........................................................................................48
III.3. Building the procedures in liquidity risk management................................................49

III.3.1. Liquidity identifying..............................................................49
III.3.2. Liquidity risk measuring.......................................................50
III.3.3. Liquidity risk controlling.......................................................51
III.3.4. Liquidity monitoring.............................................................52
III.3.5. Reporting system.................................................................52
III.4. Others recommendations................................................................................................53

III.4.1. Training program..................................................................53
III.4.2. Developing the Tienphongbank brand name.......................53
CONCLUSION.........................................................................................................................54
REFERENCES...............................................................................................................................55
ANNEX..................................................................................................................................... 56

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LIST OF FIGURES

Order

Figure

Figure 1

Framework

Figure 2

The main banking risks

Figure 3

Process of managing risks

Figure 4

Liquidity Risk Management Framework

Figure 5

Tienphongbank organizational structure

Figure 6

Tienphongbank Financial highlights June 2008-September 2009

Figure 7

Maturity Gap in VND as of 30 September 2009

Figure 8

Maturity Gap in USD as of 30 September 2009

Figure 9

Term Deposit Structure as of 30 September 2009

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LIST OF TABLE

Order

Table

Table 1

Vietnamese laws and regulations

Table 2

Tienphongbank Financial Figure (June 2008-September 2009)

Table 3

Maturity Gap in VND as of 30 September 2009

Table 4

Maturity Gap in USD as of 30 September 200

Table 5

Liquidity Ratio

Table 6

Large Fund Provider

Table 7

List of 20 Larger Fund Providers as of 30 September 2009

Table 8

Fund Structure of Tienphongbank

Table 9

Sources and Use of Fund as of 30 September 2009

TABLE OF ANNEXES

Order

Annex

Annex 1

Gap Analysis Report Format

Annex 2

Break down VND liquidity ratio as of 30 September 2009

Annex 3

Break down VND liquidity ratio as of 30 September 2009

Annex 4

The current assets and liabilities used to calculate liquidity ratios.

v


ABBREVIATIONS

Abbreviation

Description

SBV

State Bank of Vietnam

BIDV

Bank for Investment and Development of Vietnam

Tienphongbank Tien Phong Joint Stock Commercial Bank
FPT

FPT Joint Stock Investment & Technology Corporation

Mobifone

Vietnam Mobile Telecom Services Company

Vinare

Vietnam National Reinsurance Corporation

ALCO

Asset and Liability Committee

ALM

Asset and Liability Management

MCO

Maximum cumulative outflow

OBS

Off balance sheet

CAR

Capital Adequacy Ratio

IT

Information Technology

RMD

Risk Management Division

LPMs

Liquidity Procedure Manuals

LRM

Liquidity Risk Management

USD

United State Dollar

VND

Vietnamese Dong

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EXECUTIVE SUMMARY

Risk management refers to the practices used by bank managers and risk
manager to limit and control uncertainty in the bank’s total portfolio. Liquidity

risk management aims to strengthen the bank’s ability to meet its liabilities as
they come due and minimize the risk of loss from unexpected changes in the
daily business transaction.
Liquidity risk management has become an integral part of international business
strategy, and the bank use quantitative tools to measure and analyze risk. The job
of the ALCO and Risk Management Division is to identify and address all
possible scenarios for liquidity risk, establish support and control mechanisms for
dealing with it, and set the course for the risk management team in terms of its
policies and objectives.
To keep track of the myriad details of a risk management system, managers now
rely upon a wide range of new tools and technologies- computer-based trading
systems, telecommunications technology, decision support systems that quantify
liquidity risk factors, and so on. Intelligent liquidity risk management helps a
bank stabilize cash flows, reduce risk of insolvency, and focus on its primary
business.
In this study, the liquidity risk management is examined from the perspective of
the most commonly used theories to identify liquidity risk and identify the
international best practices in liquidity risk management. The studies analyze the
interplay of currencies, exchange rates, interest rates, and accounting systems.
Financial risk management is a specialized area of international accounting that
requires specific training, tools and techniques, if one is to be successful in
reduce risk for an international business.
The research assesses the case study of liquidity risk management of
Tienphongbank. In this research, I approached the issue by evaluating and
analyzing all of the current liquidity risk management procedures and liquidity
measurements which the bank has implemented, thereby, find out unreasonable
factors in these procedures. Taking into account of such findings, some
recommendations were introduced for strengthen the banks’s liquidity risk
management.
Having evaluating Tienphongbank’s liquidity risk management, I find out some

key issues such as: insufficient framework for identifying, measuring, managing
and controlling liquidity risk, no liquidity management guideline, no contingency
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plan, not setting limit for the bank’s ratio, lack of skill supervisors in this field….
Tienphongbank is now facing with high liquidity risk exposure.
Based on limited experience and practices in liquidity risk management, I have
come out to some recommendations to set up overall procedures for effective
liquidity management as strengthen the Tienphongbank capability. These include:
Strenthen the liquidity risk structure; Building liquidity standard; Building the
overall procedures in liquidity risk management.

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INTRODUCTION

1. Background of the study
The move of international banking supervision, typically the Basel II Accord has
steered much attention to risk, being inherent in any financial institution
regardless of size or geography. Visibility and sensitivity to risks are so important
for banks management since banks are “risk machines”, they take risks, they
transform them, and they embed them in banking products and services.
Moreover, banks and financial institutions act as the intermediary in the economy
with a special business field; risks if happened in any bank would not only
influence the bank itself but also caused negative effects on the economic system.
Unlike other risk, liquidity risk can lead to solvency risk and bankruptcy. In
addition, liquidity risk once happens, usually has systematic impact. Financial
market developments in the past decade have increased the complexity of

liquidity risk and its management.
The global financial crisis that began in mid-2007 re-emphasized the importance
of liquidity to the functioning of financial markets and the banking sector. In
advance of the crisis, asset markets were buoyant and funding was readily
available at low cost. The 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 a few
cases, individual institutions.
A key characteristic of the financial crisis was the inaccurate and ineffective
management of liquidity risk. Thus, identifying, controlling liquidity risk is an
essential task of Vietnamese banks in general and in Tienphongbank in
particularly. The bank needs to strengthen and implement effective liquidity risk
management in their daily operation.
2. Problem statement
The current banking system and the global financial crisis have taught
Tienphongbank that the danger of facing liquidity risk can reveal anytime due to
funding increases rapidly in assets and less capacity to meet obligations as they
come due, the capability of mobilizing capital is reduced, the concentration level
of assets and liabilities and from off balance sheet. Although Tienphongbank has
just established in June 2008, and the Board of Management understand clearly
the role of liquidity risk management, but the fact is that Tienphongbank still has
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some issues in liquidity risk management as: insufficient framework for
measuring, monitoring, controlling liquidity risk, not set up limits for the risk
management tools (gap, liquidity ratio…), undiversified the source of fund, no
contingency funding plan and lack of internal controls. These may lead
Tienphongbank facing with high potential liquidity risk exposure at the moment.

This situation requires Tienphongbank to review all of its liquidity risk
management procedure to strengthen the liquidity capacity of the system to
obtain safeness in its operation beside the profit objective in doing business.
3. Research objectives
(i)

To evaluate the liquidity risk that Tienphongbank has encountered;

(ii)

To find out the reasons leading to liquidity risk as analyzed in (i), with
a focus on the current risk management mechanisms of
Tienphongbank;

(iii)

To suggest some recommendations for monitoring liquidity risk at
Tienphongbank.

4. Research questions
To achieve these above stated objectives, the thesis aim to answer the following
questions:
(i)

What are the current levels of liquidity risk encountered by
Tienphongbank?

(ii)

What are the problems of the liquidity risk management at

Tienphongbank?

(iii)

What should be improved for the bank’s liquidity risk management?
What are the recommendations for the bank in order to control the
liquidity risk?

5. Research Methodology
The secondary data have been used for this study. The data have been collected
from Tienphongbank’s annual reports, daily reports, some banking and finance
literatures and Basel Committee Reports. These data are compared against the
common practices in liquidity management with international standard, with
Basel’s and SBV’s.
The current practices of Tienphongbank liquidity risk management were
investigated through the regulations and some reports of Tienphongbank as the
secondary sources. The analytical framework was designed as follow:

2


Figure 1. Framework
Data Collection

Secondary data

Literature reviews

 Bank report
 Bank regulations

 Newspapers
 Books
 Internet

Overview of Tienphongbank

Analysis of Liquidity risk management at Tienphongbank

Recommendations to improve Liquidity risk management at
Tienphongbank

6. Scope of study
The scope of the study is limited to the selected Tienphong Commercial Joint
Stock Bank. Within this research, the author would like to analyze
Tienphongbank’s liquidity position recently since the bank come to operations
from June 2008. For the purpose of a business management course, all the
suggestions recommended are going to concentrate on how to strengthening the
Tienphongbank internal liquidity risk management capability.
7. Structure of the Thesis
Apart from introduction and conclusion, the main body of the thesis includes
three chapters, which are:
Chapter 1: Literature review
We will study general knowledge found in the literature review. Reviewing major
concepts and definitions about liquidity risk and liquidity risk management.
Chapter 2: Liquidity risk management at Tienphongbank

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As a most important part of the research evaluates the level of liquidity risk,

calculates the indicators, discuss the current liquidity risk management at
Tienphongbank. It provides an insight into Tienphongbank’s liquidity risk
management procedures.
Chapter 3: Recommendations to improve liquidity risk management at
Tienphongbank
Some recommendations to improve liquidity risk management at Tienphongbank
are presented here. The recommendations should identify including:
strengthening the liquidity management, building the regulatory compliance
framework, upgrading the liquidity measuring and monitoring structure and
building the contingency plan framework.

4


Chapter I
LITERATURE REVIEW
I.1. Banking Risks
In economics and finance literature, risk has been a subject of interest and study
in many fields including management science, decision science, and
psychology. In general, risk is the uncertainty in the future, and has been
traditionally separated into two categories: pure risk or speculative risk. A pure
risk is a chance of loss or no loss, and a speculative risk is characterized as a
chance of loss or gain. The general usage the convention is to focus only on
potential negative impact to some characteristic of value that may arise from a
future event.
Any definition of risk is likely to carry an element of subjectivity, depending upon
the nature of the risk and to what it is applied. As such there is no all
encompassing definition of risk. Smith (1999) defines risk as “Risk is the actual
exposure of something of human value to a hazard and is often regarded as the
combination of probability and loss”. When there are a range of possible outcomes

but no assumed probabilities, there is only uncertainty. The problem with risk
management is that it concerns events that have yet to transpire, which are in turn
dependent upon events which may not be knowable at the time of prediction, that
are also dependent upon events, and so the cause effect chain continues.
We also know many definitions of risk that vary by specific application and
situational context. In statistical decision theory, risk is defined as the expectation
value of the loss function understood as a function of probability of event
occurring and the impact of event occurring. In statistics, risk is often mapped to
the probability of some event which is seen as undesirable. In information
security, a risk is written as an asset, the threats to the asset and the vulnerability
that can be exploited by the threats to impact the asset. Financial risk is often
defined as the unexpected variability or volatility of returns and thus includes
both potential worse-than-expected as well as better-than-expected returns. The
next part of this chapter would analyze type of risks in banking service – an
important component of the financial system.
I.1.1 Main types of risk in the banking service
Commercial banks are in the risk business. In the process of providing financial
services, they assume various kinds of financial risks. Risks in banking system if
occur would influent not only the banks themselves but all other fields of the

5


economy. The risks associated with the provision of banking services differ by the
type of service rendered.
Banking risks are defined as adverse impacts on profitability of several distinct
sources of uncertainty; however the following types of risk are mentioned in
Commercial Bank Risk Management (Santomeo, 1997): market risk, credit risk,
interest rate risk, liquidity risk, operational risk, foreign exchange risk and legal
risk. We can have clear definition of these risks as follows:

Market risk is the risk of asset value change associated with systematic factors.
By its nature, this risk can be hedged, but cannot be diversified completely away.
In fact, market risk can be thought of as undiversifiable risk. All investors assume
this type of risk, whenever assets owned or claims issued can change in value as
a result of broad economic factors.
Credit risk arises from non-performance by a borrower. It may arise from either an
inability or an unwillingness to perform in the pre-committed contracted manner.
This can affect the lender holding the loan contract, as well as other lenders to the
creditor. Therefore, the financial condition of the borrower as well as the current
value of any underlying collateral is of considerable interest to its bank.
Liquidity risk can best be described as the risk of a funding crisis. While some
would include the need to plan for growth and unexpected expansion of credit, the
risk here is seen more correctly as the potential for a funding crisis. Such a situation
would inevitably be associated with an unexpected event, such as a large charge
off, loss of confidence, or a crisis of national proportion such as a currency crisis.
Operational risk is associated with the problems of accurately processing,
settling, and taking or making delivery on trades in exchange for cash. It also
arises in record keeping, processing system failures and compliance with various
regulations. The Basel Committee defines operational risk as: “The risk of loss
resulting from inadequate or failed internal processes, people and systems or
external events. It includes legal risk, but excludes strategic risk and reputation
risk” (International Convergence of Capital Measurement and Capital Standard,
2006).
Legal risks are endemic in financial contracting and are separate from the legal
ramifications of credit, counterparty, and operational risks. New statutes, tax
legislation, court opinions and regulations can put formerly well-established
transactions into contention even when all parties have previously performed
adequately and are fully able to perform in the future.

6

Figure 2. The main banking risks
Credit
Interest Rate
Market

Banking Risks

Liquidity
Operational
Foreign

Exchange
Others risks: Legal
risk, Country
risk,
counterparty
risk

Although there are many types of banking risks, and all financial institutions face
all these risks to some extent, but the research only focuses on the liquidity risk –
the risk that banks have to face in their everyday operation.
I.1.2. Liquidity risk
When talking about liquidity we mean market liquidity which is the ability to buy
or sell an asset on a market. In general the market liquidity is the ability to
transform assets into cash or vice versa. Or in a more relevant context in finance,
it is the ability to quickly liquidate big volumes to low costs when assets have to
be converted into cash.
Liquidity which is represented by the quality and marketability of the assets and

liabilities exposes the bank to liquidity risk. Liquidity is necessary for a bank to
compensate for expected and unexpected balance sheet fluctuations and to
provide funds for growth. Liquidity risk normally arises due to the nature of the
assets and liabilities of the banks and most of the result from the potential
inability of a bank to generate cash in order to meet the commitments when they
are due. Once the maturity of the assets exceed of those liabilities, there is
inevitably liquidity risk. The liquidity position of a bank is normally influenced
by the investment and financing decisions of the bank and liquidity position
should be monitored both in the long run and also on a day to day basic.

7


I.2. Risk management
I.2.1. Role of risk management in banking activities
Risks are difficult to define and to avoid; people try to set up a mechanism to
identify and control risks. Thus, risk management has become an integral part of
international business strategy, and accountants use quantitative tools to measure
and analyze risk. The job of the Chief Risk Officer is to identify and address all
types of risk, establish support and control mechanisms for dealing with it, and
set the course for the risk management team in terms of its policies and
objectives. The process of risk management consists of several steps as shown in
Figure 3 (Bruno Brühwiler, Materials of Risk management workshop of
University of Applied Sciences Northwestern Switzerland, Hochiminh, Novemer
2008):
Figure 3. Process of managing risks

Source: Bruno Brühwiler, Materials of Risk management workshop of University of
Applied Sciences Northwestern Switzerland, Hochiminh, Novemer 2008

In fact, the risk-management process is becoming an increasingly important
financial area for virtually all financial institutions. With the dramatically
growing costs of losses from different risk sources, bank firms can gain a
competitive cost advantage through the development of a set of cost-effective and
efficient risk-management strategies. The advantages of a well-managed risk
management program include not only a lower total loss cost and an improved
8


business bottom line, but also an increased predictability of future losses and cost,
which ensures greater budget control and reduced ambiguity for future net
revenue stream. Bank is a portfolio of risks, the best practice in modern banking
risk management is to manage, not eliminate them. The watchwords are risk by
choice, not by chance, no risk, no reward. We should manage in the manor that
risk management for value creation.
Modern banking risk management structure was described clearly in “Risk
management in banking”. According to Bessis (2002), risk management
combines top-down and bottom-up processes with ‘horizontal’ processes. Top
down is starting with the management commitment, earnings targets and risk
limits are defined. These will lay down into strategic, operational, and process
management with signals translated to business units respectively. The
monitoring and the reporting of risk are bottom-up oriented, starting with
transactions processing and ending with consolidated risks, earnings targets. The
aggregation is required for supervision purposes and for comparison at all levels
where decisions are made. Illustrated as Figure 4 below, the process involves the
entire banking hierarchy from top to bottom, in order to turn targets into business
unit signals, and from bottom to top, to aggregate risks and profitability and
monitor them.

9

Figure 4. Liquidity Risk Management Framework

wn

Risk em
g
Mana
ent

o
Top D

Management
Commitment

Strategic
Management

Liquidity Risk
Management

Process
Management

m
Bottto
up

Source: Bruno Brühwiler, Materials of Risk management workshop of University of
Applied Sciences Northwestern Switzerland, Hochiminh, Novemer 2008

The development of bank risk management organization is an ongoing process.
The original traditional commercial bank organization tends to be dual, with the
financial sphere versus the business sphere. The business lines tend to develop
volume, sometimes at the expense of risks and profitability, while the financial
sphere tends to focus on profitability, with dedicated credit and market risk
monitoring units. This dual view is fading away with the emergence of new
dedicated functions implemented bank-wide. Modern risk management also
gives prominence to the quantification of risks with the support of the
information technology. Here under is the comparison between the traditional
and modern risk management:
Mind set and Skill set

Mind set

Skill set

Result

Old Paradigm
- Regulatory
- Internal control
- Backward looking approach
- Perform Audits
- Set Limits
- Measure Exception
- Risk management as
COMSTRAINT

New Paradigm
- Risk culture become an
integral part of every business
decision
- Forward looking approach
- Risk based business decision

- Risk management as
ENABLER

10


Although all risk management tend to fit in a common basic framework, and the
changes in risk management process would affect all types of risk, each of them
still require different techniques to control. That is the reason now we turn our
discussion to the key subject of the thesis – the liquidity risk management.
I.3. Liquidity risk management
Liquidity is the bank’s ability to fund increases in assets and meets its financial
obligations as they come (Basel: Sound Practice for Managing Liquidity in
Banking Organizations, BCBS, February 2000). Within this definition is an
assumption that obligations will be able to be met “at reasonable cost”. Liquidity
risk management seeks to ensure a bank’s ability to continue to do this. Effective
liquidity risk management helps ensure a bank's ability to meet cash flow
obligations, which are uncertain as they are affected by external events and other
agents' behavior. Liquidity risk management is of paramount importance because
a liquidity shortfall at a single institution can have system-wide repercussions.
Liquidity risk management of a bank is defined as the frame work, set of
instruments and rules the bank uses in order to control its price consistently with

its ultimate goal (Ulrich Bindseil, Central Bank Liquidity Management, April
2000, Page 2).
The international practices for managing liquidity in banking systems were
introduced by the Basel Committee on Banking Supervision through its
documents in “Sound Practices for managing liquidity in banking organizations”
Basel, February 2000, in “Principles for sound liquidity risk management and
Supervision” BIS, September 2008. According to Basel, the liquidity risk
management each bank not distinguishes any size of scope of operation, should
include the following components:
- The structure for managing liquidity risk (policy, reporting structure,
responsibilities…)
- The framework for measuring and monitoring net funding requirement
- Internal controls for liquidity risk management
I.3.1. International liquidity risk management structure
Each bank should determine key matters pertaining to liquidity risk management
policies. Such a policy relate to basic asset and liability management policies,
risk planning and market risk management and proposes responses to
emergencies such as sudden market changes. Such a policy should also enunciate
specific policies on particular aspects of liquidity management, such as the

11


relative reliance on the use of certain financial instruments and the
encouragement of closer relationships with supervisors.
The ALM & market risk management committee should be established. The chief
risk officer is responsible for matters relating to liquidity risk management
planning and operations and is responsible for monitoring market risk, reports
and analyses, proposals, setting limits and guidelines, and formulating and
implementing plans relating to market risk management.

The bank should set up liquidity limit. Limits on liquidity risk are discussed and
coordinated by the ALM & market risk management committee, discussed
further by the executive management committee and determined by the chief
executive officer.
A bank must have adequate information systems for measuring, monitoring,
controlling and reporting liquidity risk. Reports should report to the chief
executive officer on a daily basis and to the board of directors and the executive
management committee on a regular basis. The bank has constructed a system
under which they will be able to respond smoothly in the event of emergency
situations that affect our funding by establishing action plans.
I.3.2. Framework for measuring and monitoring net funding requirement
Under Basel Accord the typical framework is requiring each bank should
establish a process for the ongoing measurement and monitoring of net funding
requirements. This is essential for adequately managing liquidity risk. The
liquidity measurement involves assessing all of a bank’s cash inflows against its
outflows to identify the potential for any net shortfalls going forward. This includes
funding requirements for off-balance sheet commitments. An important aspect of
managing liquidity is making assumptions about future funding needs. While
certain cash inflows and outflows can be easily calculated or predicted, banks must
also make assumptions about future liquidity needs, both in the very short term
and for longer time periods.
Another requirement is that the bank should analyze liquidity utilizing a variety
of “what if” scenarios. In order to evaluate whether a bank is sufficiently liquid
depends in large measure on the behavior of cash flows under different
conditions. Analyzing liquidity thus entails laying out a variety of "what if"
scenarios. Under each scenario, a bank should try to account for any significant
positive or negative liquidity swings that could occur. These scenarios should take
into account factors that are both internal (bank-specific) and external (marketrelated). While liquidity will typically be managed under “normal” circumstances,
the bank must be prepared to manage liquidity under abnormal conditions.
12

Beside that the bank should also review frequently the assumptions utilized in
managing liquidity to determine that they continue to be valid. Since a bank’s
future liquidity position will be affected by factors that cannot always be forecast
with precision, assumptions need to be reviewed frequently to determine their
continuing validity, especially given the rapidity of change in banking markets.
The total number of major assumptions to be made, however, is fairly limited.
Ensuring adequate liquidity is a never-ending problem for bank management that
will always have significant implications for the bank’s profitability. To do this,
liquidity managers should estimate exactly the liquidity needs of the banks.
I.3.2.1. Measuring liquidity requirements
In recent year, several liquidity measurements methods have been developed for
estimating the bank’s liquidity requirement such as the sources and use of fund
approach, the structure of fund approach, and liquidity indicators approach. Each
method is built under some assumptions and estimated only an approximation of
actual liquidity requirement at any given time. That is why a liquidity manager
must always be ready to adjust the anticipated liquidity requirement as new
information becomes available. In fact, most banks make sure their liquidity
reserves include both a planned component, consisting of the reserves called for
by the latest liquidity forecast, and a protective component, consisting of an extra
margin of liquid reserves over those dictated by the most recent forecast. The
protective liquidity component may be large or small, depending on
management’s philosophy and attitude toward risk.
The Sources and uses of fund approach
According to Rose, Peter S (1999), the sources and uses of fund method begin
with two simple facts: (i) The bank liquidity rise when deposits increase and
loans decrease; (ii) The bank liquidity declines when deposit decrease and loan
increase.
Whenever the bank sources and uses of liquidity are mismatched, the bank faces

with liquidity gap. Liquidity gap is the difference between cash inflows and cash
outflows in each period, the excess or deficit of funds, becomes a starting-point
for a measure of a bank's future liquidity excess or shortfall at a series of points
in time. Typically, a bank may find substantial funding gaps in distant periods
and will endeavor to fill these gaps by influencing the maturity of transactions so
as to offset the gap. Banks will typically collect data on relatively distant periods
so as to maximize the opportunities to close the gap before it gets too close. Most
banks would regard it as important that any remaining borrowing requirement
should be limited to an amount which experience suggests is comfortably within
13


the bank's capacity to fund in the market.
The key steps in the sources and uses funds approach are as follows: (i) Loans
and deposits must be forecasted for a given liquidity planning period; (ii) The
estimated change in loans and deposits also is calculated for that same planning
period; (iii) Nets funding requirement must be estimated for that planning period
by comparing the estimated change in loans to estimated change in deposits.
This method uses wide variety of input information, so, expected loans and
deposits are accurate/reliable data in comparison to the fact. But, it is rather
complicated and requires that bank has a good knowledge on statistics and has
got enough information.
The Structure of fund approach
Another approach to estimate a bank’s liquidity requirement is the Structure of
funds method. In the first step, the bank’s deposits and non-deposit liabilities
sources are divided into 03 categories based on their estimated probability of
being withdrawn:
-

“Hot” funds: deposits and other borrowed funds that are very sensitive to

interest or surely will be withdrawn during the current period.

-

“Vulnerable” fund: customer deposits of which a substantial portion,
perhaps 25 or 30 percent, will probably be withdrawn from bank
sometime during the current time period.

-

“Stable” funds (also called Core deposits or core liabilities): fund that
management considers most unlikely to be withdrawn from bank) except
for a minor percentage of total).

Second step, the liquidity manager must set up liquid funds according to desired
operating rule for each of three kinds of funding sources. For example, the bank
rule decided to set up 95 percent of liquid reserve for hot funds (after excluding
any required reserve at the Central bank). The same approach applies so as to
result in 30 percent of liquid reserve for vulnerable funds and 15 percent for
stable funds.
The bank total liquidity requirement is subjective estimates that rely heavily on
management’s judgment, experience, and bank attitude toward risk.
The Liquidity ratio method
Banks can use various ratios to measure the liquidity requirements. These ratios
use in comparing with industrial averages to make the bank decision.

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Cash position ratio, cash and deposit at other financial institutions divided by

total assets. A higher ratio in comparison to industrial average shows a strong
ability to handle immediate cash needs. Common bank cash liquidity ratios –
simply variations on corporate working capital ratios – include cash divided by
total assets and quick assets divided by total assets; the higher the ratios, the
more liquid the asset portfolio.
Hot money ratio, the money market assets (cash, short term treasury bills)
divided by money market liabilities (inter-bank deposit and borrowing). The ratio
reflects whether the banks have balanced its position in money market or not.
Borrowing ratio, such as total deposits divided by borrowed funds, volatile funds
divided by liquid assets, and volatile funds minus current assets divided by total
assets minus current assets, measure a bank’s need to use volatile borrowings to
support business. High ratios indicate a larger amount of deposit turnover or
volatile funding in a bank’s total plan, which can create liquidity pressure.
The loan to deposit ratio, or total loans divided by total deposits, indicates the
degree to which a bank can support its core lending business through deposits; a
refinement of this ratio excludes from total deposits the more stable retail
component, to demonstrate the degree to which credit business is truly supported
by hot money.
Core deposit ratio: core deposit dived by total assets, where core deposits are
defined as stable fund.
Banks typically compute an overall ratio to provide a picture of the total liquidity
position. It is important to note that in some jurisdictions, banks are required to
produce specific liquidity measures as evidence of their financial strength. These
might be duplicates of those already produced and used internally, or they might
be supplemental. Other regulators impose their own liquidity metrics to
determine whether an institution is being managed prudently.
These ratios could be vary depend on the government regulations and internal
bank’s policy. However, each of them should be compared with the average value
of that ratio for banks of comparable size in a similar location and market
environment. Moreover, bank managers usually focus on changes in their

institution’s liquidity indicators rather than on the level of each ratio. They want
to know whether liquidity is rising or falling and why.
I.3.2.2. Liquidity risk management policy
Preparing suitable strategies for liquidity risk management is drawn the attention
of a bank’s board of directors. Over the years, the banking industry has several
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