Liquidity Risk Management

While introducing the concept of asset-liability management it has been mentioned that the object of any ALM policy is twofold – ensuring profitability and liquidity. Working towards this end, the bank generally maintains profitability/spreads by borrowing short (lower costs) and lending long (higher yields). Though this process of price matching can be done well within the risk/exposure levels set for rate fluctuations it may, however, place the bank in a potentially illiquid position. 

Efficient matching of prices to manage the interest rate risk does not suffice to meet the ALM objective. Price matching should be coupled with proper maturity matching. The interlinkage between the interest rate risk and the liquidity of the firm highlights the need for maturity matching. The underlying implication of this interlinkage is that rate fluctuations may lead to defaults severely affecting the asset-liability position. Further in a highly volatile situation it may lead to liquidity crisis forcing the closure of the bank.

Thus, while management of the prices of assets and liabilities is an essential part of ALM, so is liquidity. Liquidity, which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk. Though the management of liquidity risk and interest rate risks go hand in hand, there is, however, a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination risk does result in long-term sustenance. Before attempting to analyze the elimination of liquidity risk, it is essential to understand the concept of liquidity management.  

The core activity of any bank is to attain profitability through fund management i.e. acquisition and deployment of financial resources. An intricate part of fund management is liquidity management. Liquidity management relates primarily to the dependability of cash flows, both Inflows and outflows and the ability of the bank to meet maturing liabilities and customer demands for cash within the basic pricing policy framework. Liquidity risk hence, originates from the potential inability of the bank to generate cash to cope with the decline in liabilities or increase in assets.  

Thus, the cause and effect of liquidity risk are primarily linked to the nature of the assets and liabilities of the bank. All investment and financing decisions of the bank, irrespective of whether they have long term or short term implications do effect the asset-liability position of the bank which may further affect its liquidity position. In such a scenario, the bank should continuously monitor its liquidity position in the long run and also on   a day-to-day basis.