Liquidity risk management
The framework for liquidity risk management comprises three major aspects that every banking organization must consider in this regard. These are the measurement and management of the net funding requirements, market access consideration, and contingency planning (Greuning & Bratanovic 2009, p.195). The construction of a maturity ladder is vital in the analysis of a bank’s net funding requirements. It is considered important for a bank to estimate its expected cash flow on regular basis.
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The maturity ladder facilitates the bank’s comparison of its future cash inflows and outflows, which is an essential undertaking in liquidity evaluation. In this regard, a bank can determine its future liquidity excess or deficit over a given span by establishing the cash inflows and outflows difference over the particular period. Thus, the bank can manage its liquidity by influencing transactions. A bank’s data collection strategies should facilitate the mitigation of a liquidity crisis. A bank’s borrowing requirement should remain within an amount that the bank can fund in the market without any undue strain.
The cash flow behavior under varied scenarios allows the evaluation of a bank’s liquidity sufficiency, which assists the management in decision-making (Rossi & Rochon 2003, p.26). In the first scenario, which considers the normal cash flow behavior, a bank establishes a benchmark upon which the management of net funding requirements eliminates cases of temporary constraints on a bank’s ability to roll over liabilities because of market disruptions.
The second scenario considers a bank’s severe liquidity crisis emanating from the bank-specific problems not relate directly to its liquidity. The bank’s ability to honor its deposits in such a scenario allows the management time to address underlying issues. The third scenario considers a general market liquidity crisis. In this scenario, the widening difference in funding access among financial institutions resulting from credit quality would benefit some banks and adversely affect others in matters such as depositors’ funds. The bank also considers the central bank’s role in this regard.
Considering a bank’s liquidity profile under various scenarios provides insight into the bank’s liquidity, which allows the evaluation of the bank’s assumption consistency and reality about liquidity management (Goldstein & Turner 2004, p. 95). Although the appropriate period for active liquidity management is short, consideration of the information on requirements beyond the period is vital. A bank involved in the long-term assets and liabilities market should employ a long period in its liquidity management. Furthermore, in this regard, a bank’s decision making regarding certain markets reliability can use the relevant information.
A bank needs to undertake a continued review of its various assumptions in liquidity evaluation due to the unforeseen changes in the banking market. These assumptions consider the bank’s assets, liabilities, off-balance-sheet activities, and other operations whose fluctuations can considerably affect a bank’s liquidity level (Madura 2008, p.491). The assumptions regarding assets consider their influence on a bank’s cash flow. In this regard, a bank considers the proportion of renewable maturing assets, the level of accepted new loan requests, and the funding of commitments to lend. A bank may use its historical patterns, conduct a statistical analysis considering the determinants of loan demand, or make judgemental business projections in its normal funding estimation.
Moreover, the evaluation of the renewing of maturing assets and the new asset’s acquisition focuses on the reduction of contractual cash flow. A bank evaluates its liabilities behavior that could result in reduced cask outflows projected from contractual maturities. It also evaluates liabilities that are likely to remain within the bank during mild difficulties and that tend to change their behavior in a crisis. Including the cash flows arising from a bank’s off-balance-sheet activities in liquidity analysis further enhances liquidity management (Padmalatha 2011, p.417). A bank with diversified liabilities and sources of funds portrays effective liquidity management, which ensures the mitigation of adverse outcomes during a crisis.
Concerning the enhancement of a bank’s liquidity, it is essential to review factors such as the bank’s diversification of liabilities, which influences the liability security. To attain the appropriate levels of liabilities diversification, it is significantly important for a bank to evaluate its level of dependence on individual funding sources. In this regard, the bank should consider the nature of the fund’s provider and the geographical market among other considerations (Reddy 2011, p.95).
Having a good relationship with some fund providers is considered beneficial for a bank in terms of solving liquidity problems. This is an integral component of a bank’s liquidity management. A bank should also undertake the improvement of its borrowing capacity through various measures such as the improvement of asset sales. In this regard, a bank can evaluate its ability to undertake sales during a crisis by making various loan considerations. Furthermore, it is essential to consider some asset-sales markets’ regularity of use.
A bank’s contingency plans determine its ability to withstand a net funding requirement either in a bank-specific liquidity crisis or in the case of a liquidity crisis in the general market (Chorafas 2002, p.139). These plans should address the bank’s preparations concerning access to cash during a crisis. A critical evaluation of these considerations provides the bank’s management with a better insight into the matters regarding liquidity crisis.
A bank’s strategy for dealing with a liquidity crisis comprises of various components, the most important of which is managerial coordination. The bank should ensure effective information flow to various players in the organization to facilitate decision-making. Appropriate strategies should ensure that every individual is aware of his or her responsibility during a crisis to avoid resource wastage and instances of omission, which may result in adverse outcomes.
A bank should consider the course of action regarding the altering of assets and liability behaviors. Another consideration is a bank’s relationship with borrowers, liability holders, and trading and off-balance-sheet counterparts. During a crisis, banks require to conduct tradeoffs with some customers for liquidity purposes. The bank needs to classify borrowers and trading customers as per their level of importance to the bank for the appropriate actions during a crisis (Hoelscher & Quintyn 2003, p.11). A bank enhances its security regarding the source of funds during emergencies by maintaining a healthy relationship with beneficial stakeholders such as lenders when the bank is not undergoing any crisis.
A bank’s contingency plan should consider the strategies making up cash flow shortfall during emergencies. Various sources of funds such as unused credit facilities are beneficial to a bank in this regard. Depending on the nature of the crisis, a bank may choose from a variety of sources for mitigation purposes. The adoption of appropriate policies concerning these sources will considerably benefit a bank during when dealing with liquidity issues.
The bank should identify both extreme liquidity needs and the available options in this regard. These considerations differ between the large and small banks as the large banks have a better capacity to control their liabilities with respect to their level and composition. Thus, they can select from a wide variety of options to obtain the most cost efficient method of fund generation. The liquid asset cushion depends on the access to the money market. A bank should ensure that its reputation in the financial community positively influences its magement options.
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The process of corporate governance comprises of several practices that are crucial elements to any banking organisation. To ensure the appropriate operation and financial soundness of a bank, the board of directors’ members should be qualified as per their post, with a clear understanding of their role in governance (Mallin 2007, p.36). Their decisions should be professional and devoid of any influences that may adversely affect a banking organisation.
In this regard, a bank can enhance its independence and objectivity by having a supervisory board of auditors that is separate from the management board. Such an approach can facilitate new perspectives that will improve the management. A periodical evaluation of the board’s performance is vital in indentifying any weaknesses and the appropriate corrective measures.
The lack guiding corporate values in a banking organisation hampers the execution of various activities. In this regard, it is considerably important for the board of directors to establish strategic objectives and high standards of professional conduct that will ensure the bank’s activities consider the shareholders and depositors interests (Plessis et al. 2010, p.13). Furthermore, the board should ensure the communication of these standards and objectives throughout the organization.
Persistent professional practices enhance an organization’s credibility and trustworthiness in both its short term and long terms operations as unethical practices are discouraged. Moreover, the board should ensure the development and implementation of policies that indentify potential conflicts of interest in the organisation, and their management. The execution of such business activities should be independent from each other. In addition, where a bank is subject to state supervision, an administrative separation of the ownership and banking supervision functions will minimise political interference in the bank’s supervision.
However, caution is necessary to avoid interference with the information directed to clients. The adopted policies should ensure that transactions observe the terms that are to the interest of the bank, shareholders, and depositors (Klein 2005, p.40). A bank should adopt corporate values that promote employees communication of various issues without the fear of any reprisals. Encouraging employees reporting of unethical practices will prevent any adverse effects on a bank’s reputation as the board and senior management can address such issues on time.
The other element is the enforcement of responsibility and accountability throughout the organization. The senior management ensures the observation of board policies in the delegation of duties to the staff. The management system established under the guidance of the board of directors should promote accountability through effective internal control (Mullineux & Murinde 2003, p.479). In this regard, the senior managers should have the skills appropriate in the management and control over their subordinates.
The board of directors should ensure specified lines of accountability to confusing scenarios that may bring complications through slowed responses. Concerning a group structure, consideration of the bank and its parent governance responsibilities is vital (Johnson 2002, p.148). The parent board sets the general policies of the group and the subsidiaries, and determines the most appropriate governance structure guaranteeing the effective oversight for the whole group. The subsidiary bank board undertakes the governance of the bank itself, and ensures that the bank complies with its legal and regulatory obligations.
To achieve various organisation objectives, the board of directors should acknowledge the internal and external auditors as well as the internal control functions, which are vital to corporate governance (Schooner & Taylor 2010, p.106).
The board should utilise the auditors and control functions work to evaluate the information provided by the management concerning the bank’s operations and performance. It is crucial for independent directors, external auditor, and heads of the internal audit compliance and legal functions to meet annually in the absence of the bank’s management. This will enhance the bank board’s ability to oversee the implementation of its policies, and ensure that business strategies and risk exposures are consistent with the risk parameter established by the bank’s board of directors.
A bank may fail to realise its objectives and those of the shareholders due to failure to link the incentive compensation for board members and the senior management to the long-term business strategy. The board of directors should evaluate the adopted remuneration policy, the board members, and senior management compensation, and ensure that the compensation is in accordance with the bank’s culture among other considerations such as the control environment. In order to provide assurance to various bank stakeholders, it is essential for a board committee composed of a majority of independent directors to handle the remuneration policies.
This will help to avoid potential conflicts of interest. Whenever the executive directors or senior managers are eligible for performance-related incentives, their compensation should be in accordance with the conditions designed to enhance corporate value in the long-term. To avoid the creation of incentives for excessive risk-taking, the setting of the salary scales should be within the general business policy scope to avoid their dependence on the short-term performance. The remuneration policies should specify the terms under which the board members and key executives may hold and trade the bank’s stock or that of affiliated companies, as well as the relevant procedure in the granting and re-pricing of options about compensation.
Effective corporate governance requires transparency in its execution. Transparency allows a bank’s stakeholders and market participants to monitor the management and hold them accountable for their actions (Fernando 2009, p.84). In this regard, they are able to obtain sufficient information regarding the bank’s ownership structure and its aims based on which they can judge the board and senior management.
Disclosure and reporting on aspects of governance in accordance with the national laws and supervisory practice promotes market discipline while enabling various stakeholders to monitor the safety and reliability of a banking organisation. The disclosure should consider the complexity of the ownership structure, and the bank’s economic significance and risk profile among other factors. Furthermore, a bank should avail its financial statements with supporting notes and schedules to its customers so that they can have a comprehensive perception regarding the bank’s financial standing. This will facilitate their market discipline exercising.
The operational structure established by a bank, although for legitimate business purposes, may interfere with transparency. This may pose financial, legal, and reputational risks to a banking organisation. In addition, it may impede the management conduct of appropriate business oversight, which will considerably affect effective supervision. In this regard, the senior management should ensure that the bank’s operations comply with the stipulated laws and regulations.
The board of directors should ensure that the senior management establishes policies, which oversee the identification and management of risks associated with such structures. Other considerations include the setting of limits on operations. To uphold transparency, the board and senior management should document the process of consideration, authorisation, and risk management in this regard.
The lack of transparency in a bank’s operational structure exposes it to various indirect risks. Some customers may exploit such instances and use the products and services provided by the bank to undertake unethical acts. Such inappropriate acts can pose legal and reputational risks to the bank in question. Thus, it is vital for a bank to establish policies that facilitate the identification and management of various material risks that may arise from its activities.
To enhance governance, it is vital for the board and senior management to include the activities conduct in jurisdiction, or through structure in addition to the core banking businesses in the internal control reviews. Regular inspections by internal auditors ensuring that activities are within the scope of their initial purpose and the assessment of the legal and reputational risks are some of the crucial considerations. The basis of reviews frequency should consider the risk assessment. Moreover, the management should ensure that the board is aware of the existence and magement of risks identified.
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