Liquidity and Credit Risk of Banks - Research Proposal Example

Liquidity/ Credit Risk of Banks Table of Contents Part A: Research Proposal 3 Background of the Study 3 Research Gap 4 Problem ment 6 Research Objectives 6 Research Methodology 6 Limitations 7 Part B: Literature Review 9 Concept of Liquidity Risk 9 Funding Liquidity 9 Market Liquidity 10 Current Trends of Liquidity/Credit Risks in Banks 11 Sources of Liquidity Risks 11 Source of Funding Liquidity Risk 12 Sources of Market Liquidity Risk 13 Practices for Controlling Liquidity risks 14 References 15 Part A: Research Proposal Background of the Study Financial liquidity is believed as a subtle concept and has supreme importance for the well-functioning of an economy. In fact, events in 21st century bear all the marks of growing funding liquidity risk, and also expose the method of contaminating them. The recent subprime crisis of the US and its growth to international financial market have further emphasised the question regarding the causes of liquidity risks in banks. Consequently, it can be argued that there is possible association between banks’ liquidity position related understanding and screening judgements owing to the fact that lack of screening by banks and other market contributors has been cited as the fundamental causes for liquidity credit risks of banks (Nikolaou, 2009). In recent years it has been usually observed that international financial market had become quite flexible towards liquidity and credit shocks which can minimise the probability of liquidity problems intimidating individual banks in the global context. Apart from other possible aspects, it is likely that comfortable liquidity forecasting in the financial market prior to the crisis has stimulated banks to take credit risks and to diminish them by screening their mortgagors. It has further been observed during the 21st century that banks have little incentives in order to ensure high credit quality so as to deal with the liquidity risks which in turn deteriorates the liquidity positioning of the financial institutions by a greater extent (Topi, 2008). It has often been argued in this regard that the reason of liquidity risks depends fundamentally on the departure of the bank from financial markets and symmetric information model which can result in moral threat to the banks as well as its stakeholders. Contextually, liquidity or credit risk is prevalent in today’s economic system and can cause a malicious relation between funding and financial market liquidity, encouraging organised liquidity risks (Nikolaou, 2009). Undoubtedly, this particular concern raises an interesting issue to be researched in the current day context and is thus considered in this proposed research study which will be based on understanding the reasons for liquidity and credit risk for banks in the 21st century phenomenon. Research Gap It can be apparently observed with reference to the previously conducted research studies that defining and elaborating on the term ‘liquidity’ is quite difficult in relation to financial institutions. In general, liquidity risk in banks appear when a given security or property cannot be traded rapidly enough to the financial market in order to inhibit loss or to make essential revenue and therefore preserve a balance in the assets and liabilities owned by the organisation. In other words, the fundamental role of banks in maintaining short term deposits and long term loans make them inherently vulnerable to liquidity risks which further creates a substantial impact on the economy as a whole (Bank for International Settlements, 2008). According to Brunnemeier & Pederson (2007), there are two types of liquidity risks fundamentally faced by banks in the current day phenomenon, i.e. funding liquidity and market liquidity. Funding liquidity includes generating money on short notice providing people with the opportunity to make money incurring least interest rates through securities as collateral. On the other hand, market liquidity defines the cost of vending assets, especially in terms of mortgages (Strahan, 2008). Ali (2004) stated that causes of liquidity risks in banks comprise both risk of being incapable to fund collection of assets at proper maturities and risk of being incompetent to liquidate a situation in a timely method at sensible prices. At times, liquidity is demarcated with respect to maturity incongruity between assets and liabilities, while sometimes it is described as asynchronous scheduling of cash incursion and cash depletion by the financial institutions. The regulatory literature of banks describes liquidity risk as risk for bank’s incomes and capital appearing from its incapability to fulfil the liabilities in due time (Bank for International Settlements, n.d.). According to Ariffin (2012), management of liquidity is considered as one of the top priorities of banks although the prevalence of such complex causes tends to inhibit the banks’ efficiency in mitigating these risks effectively. Since there is a close relationship identified between liquidity and creditworthiness of banks, comprehensive liquidity management can effectively minimise the probability of banks to become insolvent, hence reducing the likelihoods of bankruptcies (Ariffin, 2012). It can further be argued in this context that there is a significant need to understand the current trend of liquidity and credit risks faced by the banks in the global context. Furthermore, previous literature studies can be witnessed to render significant but incomprehensive or rather complex explanation of the identified issue concerning the risks faced by the banks, its causes and the consequent measures taken by the institutions to counter such limitations. Thus, it can be affirmed that there is a need to develop a comprehensive and updated understanding of the phenomenon owing to this pertaining literature gap. Problem Statement Managing liquidity risks and credit risks has become a vital concern for banks in order to generate growth and to survive in today’s 21st century. Since exposure of liquidity and credit risk is often argued as a leading source of problems in the international banks which further increases requirement for keen awareness about identifying and controlling different risks. It is an underlying problem for banks and its consumers as well to understand the term ‘liquidity credit risks’ and the sources of these risks in order to deal with such disruptions carefully. Based on this problem, the research will intend to analyse the subject area from a different viewpoint. The proposed research therefore intends to evaluate liquidity and credit risks in selected banks in the UK. On the basis of existing literature survey, the research is further planned to concentrate on evaluating factors that generate liquidity and credit risks for banks. Research Objectives Based on the above explained research issue, the proposed study will be based on the following objectives. To assess different liquidity and credit risks of banks To understand the underlying causes of liquidity and credit risks of banks in 21st century To provide deep understanding on issues relating to liquidity risk management strategies applied by different banks Research Methodology The research will aim to evaluate the liquidity and credit risks in banks in the 21st century context. The research is planned to be entirely based on understanding industrial trends and risk management conceptions of banking. Since the research subject is exploratory in nature and the research will intend to understand in detail regarding reasons associated with historic financial occurrences, a qualitative research method will be used. Notably, it is expected that the qualitative technique will be useful in this research as it will help to identify the issues and their significance from a broader and evaluative perspective (Urban Wallace Associates, 2005). The research will follow a case study approach to analyse the collected data for the purpose of this study. It is worth mentioning in this regard that because the proposed research tends to be quite broad in nature, applying the case study analysis method will prove effective to narrow down the subject with the help of certain easily researchable examples of banks which has faced liquidity and credit risks. This will not only be helpful to structure the study and thus build its comprehensibility but shall also be beneficial in obtaining updated and rationalised understanding of the research issue (University of Southern California, n.d.). In the research, both primary as well as secondary data sources will be used. As a part of collecting primary data, structured interview process will be conducted with managers of three banks selected for the case study analysis, namely Royal Bank of Scotland (RBS), Lloyds Banking Group and Barclays Plc. Besides, secondary information will be collected from different academic journals, industrial reports, company reports, books and various online articles. Limitations The major limitation of this proposed research is to generalise the outcome of the study. Since the research is based on qualitative method, it is quite likely to be difficult to generalise the findings. Furthermore, since a case study method will be used, it might be challenging for drawing a significant cause and effect relationship about the research subject. The other limitation associated with the proposed research study is time. Since interview method will be used, it will take considerable amount of time to acquire permission from the required authorities to conduct the survey. In order to counter these limitations, appropriate research structure will be followed as per the circumstances. Part B: Literature Review Concept of Liquidity Risk On the basis of the description provided by the Basel Committee on Banking Supervision, liquidity risk appears fundamentally due to the incapability of banks to accommodate reductions in liabilities substantiating it with the rise of assets. To be precise, when a bank has insufficient liquidity, it is observed to fail in acquiring adequate funds, which in turn imposes a strong impact on the productivity of the organisation by a large extent. Decker (2000) specified in this regard that liquidity risk in banks can be divided into two categories which are funding liquidity risk and market liquidity risk (Shen & et. al., 2009). Funding Liquidity One of the major constituents of liquidity risk has been the funding activities performed by banking institutions. Banks have been found to usually deliver funding liquidity to the customers by supplying money transactions deposits. Transaction deposits allow depositors to withdraw money on demand. Since banks invest in illiquid loans, their business structure has also been termed as ‘asset transformations’ wherein banks transform loans and produce assets. These loans are further termed illiquid in nature because banks provide money to small and medium sized organisations without access to broad securities market. In order to provide such lending, banks gather private information about credit related risks, future growth opportunities of businesses and monitor borrowers throughout the period of loan. Banks also generate funding liquidity by delivering lines of credit which is also termed as loan commitments (Strahan, 2008). By its very characteristics, providing funding liquidly makes banks unsteady as they are in a situation of encouraging substantial disgorge of cash on customers’ request. Hence, it has often been argued that even though under normal circumstances, banks can fulfil liquidity demands from depositors, when the business structure is vulnerable on depositors’ expectations, the results may differ significantly. The experience of banks from fencing liquidity risk also appears from issuance of credit, which obligate these financial institutions to provide cash on demand (Strahan, 2008). Market Liquidity In past twenty years, numerous changes have been occurring in the business structure of banks. In modern approach, banks tend to create market liquidity by transforming ‘hard to sell assets’ to ‘easier to sell assets’. This business structure permits banks to sell assets to inactive depositors and to reutilise their capital to create new loans which can sequentially be transformed and sold. In this regard, banks progressively use ‘securitisation’ in order to fund their lending by generating structures such as collateralised loans, mortgages and debt requirements. These financing arrangements in turn permit banks to remove commercial loans, credit loans, and mortgages from the balance sheet. Stating precisely, Strahan (2008) noted that market liquidity risk in banks arises when banks lose the capability to sell or securitise loans at reasonable rate. In such situations, market liquidity risks feed back to funding liquidity. Generating market liquidity thus necessitates banks to accept sufficient risks to maintain inducements in order to deal sensibly with the debtor in setting prices and in applying agreements (Strahan, 2008). Emphasising on a similar aspect, Ali (2004) stated that for banks and financial institutions, liquidity risks comprise both risks of being incapable to fund assortment of properties at proper maturities and risk of being incapable to liquidate an asset at sensible price. Current Trends of Liquidity/Credit Risks in Banks According to Vodova (n.d.), banks today face numerous types of risks which comprise credit risks, interest rate risks, functional risks, market risks, liquidity risks and bankruptcy risks among others. Every bank is indulged to accept deposits and to deliver loans to several entities. Different kinds of loans are usually major part of bank’s business, which is the reason liquidity and credit risk is considered as the primary risks for banks. Credit risk in this context refer to the risk situation when a debtor is unable to repay the loan amount to the bank or that the issuer of security held by the bank on behalf of the loan is unable to meet the liabilities. Any type of loan has the possibility of partial or complete loss of the amount provided to the debtor. Huge losses created by non-repayment of loan amount by debtors can thus result in insolvency and probably to bankruptcy of banks. Subsequently, it is obvious that knowledge and practice of proper means of credit risk by observing, evaluating, supervising and mitigating have been termed as the vital tasks for every banks and financial institutions (Vodova, n.d.). Sources of Liquidity Risks Liquidity risks originate from the characteristics of banking business. With respect to macro-economic aspects, liquidity risks are exogenous to the banks. Banks therefore attempt to deliver maturity transformations taking deposits which can be callable on request of the depositors. Although maturity transformations deliver liquidity protection to the creditors, it also exposes banks towards vulnerable liquidity risks. Since banks concentrate on maturity transformations, these institutions take huge amount of deposits and pay attention to match the cash inflows and outflows with the intention of identifying and accordingly addressing the liquidity risks. In it is in this context that any kind of maturity mismatch at a particular time is considered as a significant source of liquidity risk for banks. The risk of maturity mismatch can arrive from several directions which are again found to be subjected to several aspects. In a nutshell, the sources of liquidity risks from assets side are subject to the extent of incapability of bank to exchange the assets into cash when needed without incurring loss and from the liability side. Liquidity risks are also found to originate from unexpected recollection of deposits. Assessing the credit or liquidity risks among banks, Jameson (2001) had described several behavioural and exogenous sources of liquidity risks which are listed as follows. Improper decision or accompaniment approach of banks towards the timing of cash inflow and cash outflow Unexpected changes in the cost of capital or accessibility of funding Irregular performance of the economy and its financial market Variety of expectations used in forecasting cash flows Risk of stimulation by the secondary sources such as failure of business tactics, failure of corporate governance, inadequate modelling expectations and inadequate merger and acquisition strategy Collapse in payments and clearance structure Macroeconomic inequities Source of Funding Liquidity Risk According to IMF (2008), funding liquidity risk captures the incapability of banks to serve its liabilities effectively. Typically, finding liquidity risk relies on the availability of liquidity sources (such as depositors, financial market, interbank market and central bank) and the capability to satisfy the budget limitation over a particular period of time (Nikolaou, 2009). According to Acharya (2006), funding liquidity risks arise from two key sources which are due to massive cash outflows and principally appear during periods of organising assets or liquidity shocks and due to the distinctive or organisational specific shocks. It is in this context that asset or liquidity shocks appear throughout recessions, stock market crashes, and real estate crashes. On the other hand, organisational specific shocks can arise because of deceitful activities, leak of accrued losses, accounting misdeeds, legal defrayals and weak risk management practices. These shocks are further likely to result in disorder liquidation of assets in banks and financial institutions (Acharya, 2006). Sources of Market Liquidity Risk Accordion to Kyle (1985), there are three basic dimensions of market liquidity, namely stiffness, depth and resiliency. Market stiffness reflects low expenses of undoing a specific position, signifying that the prices at which individual financial transactions can be commenced, is not quite dissimilar from usual market prices. Similarly, market depth denotes the capability to implement large monetary transactions without creating extreme impacts on the existing market prices of assets. The third factor, market resiliency, is associated with the rapidity at which market prices recuperate from random shock (Gersl & Komarkova, 2009). Practices for Controlling Liquidity risks There are several practices used by banks in order to control the liquidity risks witnessed in their regular lending transactions. According to the research of Deutsche Bundesbank (2012), in order to control the liquidity risks, banks need to certify creditworthiness at all time. Besides, banks also need to enhance the cash flow in order to minimise their dependency on external financing. At the same time, banks can also coordinate insurance of its owned instruments to have better remedy against liquidity and credit risks (Deutsche Bundesbank, 2012). In the similar context, as stated by Jenkinson (2008), banks have varieties of defences against the liquidity or credit risks faced by these financial institutions. The potential countermeasure against liquidity pressure, often adopted by banks is to transform the illiquid assets into cash. However, it is worth mentioning in this context that this counter measure can only be possible when one single organisation face liquidity problem. Additionally, this approach can be unsuccessful in lowering international demand for securitised products and extensive cessation of lending market (Jenkinson, 2008). Thus, in order to counter liquidity risks, banks need to react with funding deficit and act on asset side of the balance sheet so that they can reduce the financing requirements and subsequently maintain a liquidity margin to obtain financial balance. It is expected that this particular strategy can simplify the funding burden and improve the liquidity position of the bank. Apart from this, banks can also hold significant buffer of dependable liquid assets such as Treasury bills or other government securities through which they can extract cash instantly and fulfil the funding supplies deciphering greater efficiency (Jenkinson, 2008). References Ali, S. S., 2004. Islamic Modes of Finance and Associated Liquidity Risks. Conference on Monetary Sector in Iran: Structure. [Online] Available at: http://www.sbp.org.pk/departments/ibd/lecture_6_islamic_modes_finance_liquidity.pdf [Accessed March 04, 2013]. Ariffin, N. M., 2012. Liquidity Risk Management and Financial Performance in Malaysia: Empirical Evidence from Islamic Banks. Aceh International Journal of Social Sciences, Vol. 1, No. 2, pp. 68-75. Acharya, V. V., 2006. Liquidity Risk: Causes, Consequences and Implications for Risk Management. Economic and Political Weekly, Vol. 41, No. 6, pp. 460-463. Brunnemeier, M. & Pederson, L., 2007. Market Liquidity and Funding Liquidity. The Review Of Financial Studies. Bank for International Settlements, No Date. Principles for the Management of Credit Risk. Credit Risk Management. [Online] Available at: http://www.bis.org/publ/bcbsc125.pdf [Accessed March 04, 2013]. Bank for International Settlements, 2008. Principles for Sound Liquidity Risk Management and Supervision. Basel Committee on Banking Supervision. [Online] Available at: http://www.bis.org/publ/bcbs144.pdf [Accessed March 04, 2013]. Decker, P. A., 2000. The Changing Character of Liquidity and Liquidity Risk Management: A Regulators Perspective. Federal Reserve Bank of Chicago Banking Supervision and Regulation Research. Deutsche Bundesbank, 2012. Liquidity Risk Management Practices At Selected German Credit Institutions. BaFin. [Online] Available at: http://www.bundesbank.de/Redaktion/EN/Downloads/Core_business_areas/Banking_supervision/PDF/liquidity_risk_management_practices_at_selected_german_credit_institutions.pdf?__blob=publicationFile [Accessed March 04, 2013]. Gersl, A. & Komarkova, Z., 2009. Liquidity Risk and Banks’ Bidding Behavior: Evidence from the Global Financial Crisis. Journal of Economics and Finance, Vol. 59, No. 6, pp. 577-592. IMF, 2008. Global Financial Stability Report. World Economic and Financial Surveys. [Online] Available at: http://www.imf.org/external/pubs/ft/gfsr/2008/01/pdf/text.pdf [Accessed March 04, 2013]. Jameson, R., 2001. Who’s Afraid of Liquidity Risk? ERisk, pp. 1-3. Jenkinson, N., 2008. Strengthening Regimes for Controlling Liquidity Risk: Some Lessons from the Recent Turmoil. Bank of England. [Online] Available at: http://www.bankofengland.co.uk/publications/Documents/speeches/2008/speech345.pdf [Accessed March 04, 2013]. Kyle, A., 1985. Continuous Auctions and Insider Trading. Econometrica, Vol. 53, No. 6. Nikolaou, K., 2009. Liquidity (Risk) Concepts Definitions and Interactions. Working Paper Series. [Online] Available at: http://www.ecb.eu/pub/pdf/scpwps/ecbwp1008.pdf [Accessed March 04, 2013]. Shen, C. & et. al., 2009. Bank Liquidity Risk and Performance. National Taiwan University. [Online] Available at: http://www.finance.nsysu.edu.tw/SFM/17thSFM/program/FullPaper/083-231345511.pdf [Accessed March 04, 2013]. Strahan, P., 2008. Liquidity Production in 21st Century Banking. National Bureau of Economic Research. [Online] Available at: http://campus.unibo.it/39247/1/21CenturyBanking_Strahan.pdf [Accessed March 04, 2013]. Topi, J., 2008. Bank Runs, Liquidity and Credit Risk. Bank of Finland. 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