Cash Flow Approach for Liquidity Risk Management

The bank should first decide on the planning horizon that suits its operational style and then based on the cost constant decide on the number of forecasting periods and other such details. Following such decisions will be the assessment of the liquidity position based on the forecasts made for the cash inflows and outflows. The basic steps involved in this process are as follows: 

-  Estimate anticipated changes in deposits

-  Estimate the cash inflows by way of loan recovery

- Estimate the cash outflows by way of deposit withdrawals and credit accommodations

-  Forecast these for the end of each period

-  Estimate the liquidity needs over the planning horizon

The most critical task of liquidity management is predicting the expected cash inflows coming by way of incremental deposits and recovery of credit and the outflows relating to deposit withdrawals and loan disbursal's. In this process, accuracy levels when a bank forecasts cash outflows by way of deposit withdrawals and credit disbursal are fairly high, when compared to the cash inflow forecasts relating to loan repayments and deposit accretion. This difficulty in the forecasting of cash flows coupled with the mismatches arising due to the maturity pattern of assets and liabilities result in the liquidity risk. Thus the process of forecasting cash flows with a high degree of accuracy holds the key to risk management.

 All estimates are generally given as at the beginning of the month or at the end of the month and are silent upon the fluctuations that may occur during the month, when the forecasting period is chosen as a month. In order to manage the intra-month liquidity problems, there should always be a surplus balance. In such a scenario, it is always better for the bank to consider that the deficit occurs at the beginning of the period while the surplus occurs at the end of the period. Thus, funds should be provided to meet the deficit balance at the beginning of the forecasting period.