What is Liquidity Management?
Liquidity management refers to the strategic planning and control of a company’s cash and liquid assets to ensure it has enough funds to meet its short-term financial obligations while maximizing the returns on its liquid investments. In simpler terms, it involves monitoring, forecasting, and optimizing the availability of cash to cover day-to-day operational needs.
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What is Liquidity?
Liquidity refers to the ability of an organisation or a bank to meet all its financial obligations. It involves the conversion of assets into cash to ensure uninterrupted flow of the latter. This cash is used to meet current liabilities when due and maintain the availability of cash for day-to-day business operations.
Banks are generally assessed based on their liquidity and their ability to meet cash and collateral obligations without incurring losses. In order to transform short-term deposits (liabilities) into long-term loans (assets), banks are inherently exposed to liquidity risks.
This transformation process often faces asset and liability maturity mismatches, which is managed by the available liquidity. The process is known as liquidity management. Effective liquidity management enables a bank to increase its assets (loans and investments) and meet its obligations on time (withdrawal of deposits).
Ratios in Liquidity Management
A prudent liquidity management policy is essential to maintain a bank’s solvency. The main regulatory body for banks, i.e., RBI, has specified certain ratios that need to be maintained by all banks to ensure the liquidity of banks. These ratios are a measure of the liquidity position of a bank. These include two key ratios, namely Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
Cash Reserve Ratio (CRR)
According to Section 1 of the RBI Act 1934, banks are mandated to deposit a specified minimum fraction of the total deposits made by its customers either in cash or as deposits with the central bank. If the CRR is 4%, the bank would need to keep Rs 4 with the central bank and the remaining Rs 96 would be used for investments and lending activities.
This is one of the most important tools that are used by central banks to manage liquidity across an economy. Thus, the higher the CRR, the lower the amount that banks can use for lending and investment purposes and vice versa. In this way, the RBI is able to reduce the amount banks lend out to its borrowers. The current CRR specified by the RBI is 4% (as on 20 January 2016).
Statutory Liquidity Ratio (SLR)
The SLR is another important tool of monetary policy that plays an important role in maintaining liquidity across an economy. Banks are required to maintain a certain portion of their net demand and time liabilities as liquid assets in the form of cash, gold and unencumbered securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR).
Demand liabilities refer to the liabilities of a bank that need to be repaid to the customers or account holders on demand. It includes current account deposits, savings account deposits, other deposits, inter-bank deposits, etc. Time liabilities refer to those liabilities which have to be paid at the maturity or after the expiry of a certain maturity period.
This includes fixed deposits, recurring deposits, etc. The Net Demand & Time Liabilities (NDTL) is equal to the difference of the Demand & Time Liabilities and the bank’s deposits with other banks. The current SLR specified by the RBI is 21.5% (as on 20 January 2016).
Liquidity Management for Foreign Exchange
There are banks that have an international presence. The function of liquidity management becomes more complex for these banks because of two reasons. First, the bank may be unable to mobilise domestic currency and foreign exchange transactions to meet the demand of foreign currency. Second, the bank may know less about its foreign currency borrowers than about its domestic borrowers.
Banks having foreign currency positions need liquidity management for forex reserves as the forex market is not very liquid at all times. Therefore, banks should ideally have a system for measuring, monitoring and controlling their liquidity position in foreign currencies, especially, their major trading currencies. For this, they must analyse the possible mismatch in the expected foreign currency liquidity and their available foreign reserves. In addition, banks usually follow separate strategies for each currency.
Apart from the liquidity mismatch at a given rate, banks also need to take into account the risk associated with a sudden increase or decrease in forex rates, which can lead to large liquidity mismatches.
In some circumstances, foreign currency borrowers may not have hedged their forex positions to the required level. In such cases, the foreign currency assets may be impaired. Every bank must adopt the above-given measures to manage the liquidity issues related to forex. However, liquidity management in forex depends on each bank’s nature of business.
Some banks may fund domestic currency assets by using foreign currency deposits, while some may fund foreign currency assets by using domestic currency deposits. In each case, the bank needs to analyse and adopt a particular type of liquidity management approach for forex.
