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Banks’ Cash Flows: Managing Liquidity Risks
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Banks require funds not only to meet their own business needs but also to support various operations, including correspondent banking services for foreign banks and access to payment systems for smaller domestic banks and other financial institutions.
Liquidity Management
To ensure adequate liquidity, banks must periodically review their efforts to:
- Establish and maintain relationships with liability holders
- Diversify their liabilities
- Maintain the capacity to sell assets
Senior management must also understand how much funding they can expect from the market during normal and adverse circumstances.
Managing Market Access
Building strong relationships with key providers of funding is crucial for a bank’s liquidity management. This includes:
- Trading counterparties
- Correspondent banks
- Corporate customers
- Payments systems
The frequency of contact and the frequency of use of a funding source are two possible indicators of the strength of a funding relationship.
Concentrations in Funding Sources
Concentrations in funding sources increase liquidity risk, so banks must examine their reliance on particular funding sources by:
- Instrument type
- Nature of the provider
- Geographic market
Contingency Planning
A bank’s contingency plan should address the strategy for handling liquidity crises and include procedures for making up cash flow shortfalls in emergency situations. Senior management must determine how the bank may fare under abnormal adverse circumstances and identify the types of events that may trigger liquidity contingency plans.
The plan should also include a strategy for:
- Altering asset and liability behaviors
- Maintaining customer relationships with liability-holders, borrowers, and trading counterparties
- Making up cash flow shortfalls in adverse situations
Liquidity Risk Management
Banks must be careful not to rely excessively on backup lines and understand the various conditions that could affect their ability to access such lines. They should also have contingency plans for times when their backup lines become unavailable.
Additionally, banks engaged in secondary market credit activities should ensure that their liquidity contingency plans fully incorporate the potential risk posed by these activities.
Conclusion
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Managing a bank’s cash flows and liquidity risks is crucial to ensuring its stability and success. By regularly reviewing their funding relationships, diversifying their liabilities, and maintaining a strong liquidity buffer, banks can mitigate the impact of adverse market conditions and maintain their ability to meet customer demands.