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Liquidity risk management and assessment

Measurement and management of the net funding requirements, market access consideration and contingency planning are the three main elements of liquidity risk management and assessment that every banking organization should adopt. The construction of a maturity ladder is vital in the analysis of a bank’s net funding requirements because it allows the bank to compare its future cash inflows with the outflows, which is a crucial undertaking in liquidity evaluation. A bank can determine the future liquidity surplus or deficit over a given period by determining the cash inflows and outflows difference over the period. A bank’s data collection strategies should facilitate the mitigation of liquidity crisis. On the other hand, the bank’s borrowing requirement should remain within the range 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. 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 constrains on the bank’s ability to roll over liabilities because of market disruptions. The second scenario considers a bank’s severe liquidity crisis emanating for bank-specific problems not related to its liquidity. The bank’s ability to honor its deposits in such as scenario allows the management time to address underlying issues. The third scenario considers a general market liquidity crisis. In this case, a widening difference in funding access among financial institutions due to credit quality might benefit some banks and adversely affect others in terms of aspects such as depositors’ funds. Evaluating a bank ’s liquidity profile under different scenarios provides insights into a bank’s liquidity status, which allows the evaluation of the bank’s assumptions regarding liquidity management.

A bank needs to undertake a continued review of its assumptions in liquidity evaluation due to the unforeseen changes in the banking market. The assumptions consider the bank’s assets, liabilities, off-balance-sheet activities and other operations whose fluctuations can considerably affect the bank’s liquidity levels. The assumptions regarding assets consider the assets’ influence on the bank’s cash flow. A bank considers the proportion of renewable maturing assets, the level of accepted new loan request and the funding of commitments to lend in analyzing its assets. A bank may use the historical patterns, conduct a statistical analysis on the determinants of loan demands, or make judgmental business projections on its normal funding estimation. The evaluation of the renewal of maturing assets and new assets acquisition focuses on the reduction of contractual cash flow. A bank evaluates its liabilities behavior that could result in reduced cash outflows projected from contractual maturities. In addition, the bank evaluates the liabilities likely to remain within the bank during mild difficulties, which tend to change their behavior in crisis. One of the key strategies in enhancing liquidity management is to include the cash flows arising from a bank’s off-balance-sheet activities in the liquidity analysis. A bank with diversified liabilities and sources of funds portrays effective liquidity management, which ensures the mitigation of adverse outcomes during crisis. A bank should review factors such as the diversification of liabilities, which influences the liability security, in evaluating its liquidity. A bank should evaluate its level of dependence on individual funding sources to attain the appropriate levels of liabilities diversification. The bank should consider factors such as the nature of the funds provider and the geographical market. Having a good relationship with some fund providers is considerably beneficial for a bank in terms of solving liquidity problems. A bank should also undertake the improvement of its borrowing capacity through measures such as the improvement of asset sales, which allows the bank to evaluate its ability to undertake sales during crisis by making various loan considerations.

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