Understanding Financial Services - Assignment Example

Understanding financial services A Bank liquidity: Bank liquidity or liquidity for a bank typically means the ability of the financial institution to meet its financial obligations, as and when they appear on the bank’s books. Banks, more often than not, invest in relatively illiquid assets, however, it funds loans granted to customers with short-term liabilities. Thus, this poses a steep challenge for the bank, in terms of ensuring an adequate level of liquidity under all reasonable conditions. Being prepared in advance against any emergency situation is the first and foremost benefit of having adequate liquidity. Emergencies can hit a bank very hard without warning. When these emergencies occur, a bank would always want to have adequate cash reserves in its possession, which would serve as an immediate financial cushion. These cash liquids are in contrast with the non-liquid assets such as, real estate, that although is very valuable, but are hard to liquidate when in emergency. So, having an adequate liquidity always puts a bank in advantageous position as it can pay off its immediate obligations without any problem. Another advantage associated with holding liquid assets such as, a money-market account, is that it can optimize the bank’s investment portfolio. The bank can use the liquid asset in order to make new investments at an optimal time, without selling its other investments. It gives the bank a flexibility to sell those investments, as and when they deem appropriate. This improves the performance of the bank significantly and ensures its long-term sustainability. Given the fact that liquid assets can be sold quickly and more often than not, fetch full value to the seller, banks with adequate liquid reserves will always be in a less risky position, at the time when the market is associated with uncertainty. During an economic crunch, when the market dries down, investors tend to get nervous. In such cases, banks in order to ensure its stability might have to sell its non-liquid assets, but only after incurring a huge loss. However, if they have liquid assets in their reserve, then they would be shielded against any market uncertainty as certain liquid assets are insured by the federal government. Thus, a bank has very feeble chance of losing the value (Arif and Anees, 2012). A. 2. During the financial crises that shook the economy throughout the world, we witnessed a new type of bank run, where both the assets and liabilities of the bank were equally affected. The bank run on Bear Sterns was quite different from traditional bank runs, in which depositors tend to run to the bank in order to withdraw their deposits, which renders the bank illiquid. The bank run on Bear Sterns happened when the hedge funds, that placed their liquid wealth with prime brokers, retrieved those funds. Although the type was a little different, the runs on these financial institutions are quite similar to traditional bank runs. The similarity is prominent when the financial institutors have to execute a costly liquidation of their investments in order to repay their debt (Wang, 2013). This explains the impact of illiquidity on banks from one perspective. Banks with inadequate liquidity are exposed to liquidity risk, where they are in no position to pay off their debt obligations. They suffer huge losses while selling off their investments at a devalued rate. This deteriorates the financial performance of banks significantly. Another example that can be pointed out with respect to explaining the effects of illiquidity is the case Northern Rock. Before the bank run happened in Northern Rock, it was the fifth-largest bank in the United Kingdom, in terms of the value of mortgage assets. The case of Northern Rock has been studied in detail by Shin (2009). In this case, depositors queued outside the office in order to withdraw their deposits and ultimately, the organization had to declare bankruptcy. Possessing inadequate liquid reserves affects the bank’s business significantly. They are not in a position to make any fruitful investments and thus, it significantly reduces the profit margin that a bank could generate in a financial year. Moreover, if the market perceives that the bank has inadequate liquid reserves, then that will have an adverse effect on the bank. This negative perception would trigger a chaos in the market and depositors will tend to withdraw their deposits. In such case, an illiquid bank would be incapable of meeting the demand of its customers and as a result, its reputation will be significantly tarnished. Its share price will fall rapidly and investors will incur huge losses. Furthermore, external investors, more often than not, tend to evaluate the amount of liquid reserves a bank has. They believe that the higher the amount of liquid reserve a bank possesses, the better off the bank is. They tend to invest in those banks which have adequate liquid reserves and given this fact, a bank with inadequate liquid reserve loses these investments. B. Liquidity is referred to as a banks capability to fund its increase in assets as well as its ability to pay off both anticipated and unanticipated cash and collateral obligations at a nominal cost, without incurring much loss. Liquidity risk refers the banks incapability to meet such obligations, as and when they become due on the banks book, affecting its financial conditions severely. Thus, effective liquidity management is of utmost importance that helps a bank to ensure that it possesses the capability to meet its obligations, as and when they appear on the banks books, thereby reducing the probability of development of an adverse situation that might put the banks business into jeopardy (Repullo, 2004). The recent bank runs that have taken place, mainly in the western countries, have highlighted several deficiencies that exist within a banks operational framework, as far as liquidity risk management is concerned. These deficiencies include inadequate holding of assets, funding illiquid asset portfolios that are very risky with short-term liabilities and potentially volatile. In addition to that, improper cash flow projections and liquidity contingency plans are also other deficiencies present in banks. A bank is primarily responsible for the proper management of liquidity risk. It should formulate a robust framework for liquidity management that will ensure that it has adequate liquidity, which includes a reserve of unencumbered superior quality liquid assets in order to be able to tackle uncertain events, such the impairment or loss of both secured and unsecured funding sources. The bank supervisors should focus on assessing the liquidity position of banks and should adhere to strict measures in case the bank is deficient in any of the areas, so as to be able to protect the depositors as well as to limit the potential damage that illiquidity can cause to the financial system (RBI, 2012). The management of the bank should clearly contrive a liquidity deficiency tolerance that would be appropriate for their business strategy and its contribution in the financial system. The senior management should focus on formulating strategies, action plans and policies in order to be able to tackle the liquidity risk, in accordance with liquidity deficiency tolerance level, as well as to be able to pool up adequate liquidity. They should consistently reassess the available information regarding the banks liquidity developments and report the same to the board members on a regular basis. Thereafter, the banks board members would be responsible for reviewing and approving the strategies, action plans and policies to be followed in order to manage liquidity efficiently. They need to supervise the fact that the senior management is managing the liquidity risk effectively (Bouwman, 2013). The bank can include the liquidity costs, risks and the associated benefits in its internal pricing, product approval and performance measurement process for all the major business activities, whether they are on balance sheet or off balance sheet. They can align the incentives, which they receive from taking risk in individual business lines, with the liquidity risk exposure created by those activities. They can develop a robust process for identifying, measuring, monitoring and managing the liquidity needs and take actions accordingly. The actions involve comprehensive prediction of all future cash flows from assets, liabilities and off-balance sheet items over a particular time period (RBI, 2012). The bank should supervise and manage the liquidity risk exposures as well as the funding requirements within the legal units, business entities as well as currencies, thereby considering the regulatory, legal and operational restrictions, as far as transferability of the liquid assets is concerned. The bank management body should cater to formulate an efficient and effective funding strategy, which will provide the bank with effective diversification, as far as the sources as well as the tenor of funding is concerned. The strategy should be directed towards maintaining a fragmentary presence in order for the bank to be able to promote effective and efficient diversification of the sources of funds. In addition to that, the management should analyse and evaluate the banks capability to raise finance rapidly from each of those funding sources. They should clearly focus on recognizing the major factors that have a significant impact on its ability to pool up finance from the multiple sources and scrutinize those closely and appropriately in order to make sure that the predictions, being made regarding the fund raising capability of the bank, are reliable and valid (Bouwman, 2013). Furthermore, the bank should also put extra effort in managing its daily liquidity positions and risk exposures vigorously in order to be able to meet the payment and settlement oriented obligations on a regular basis (Varotto, 2011). This process should be initiated and conducted regularly, under both usual and stressed situations. If done appropriately, this process will have a significant contribution towards a swift functioning of payment and settlement process. Alongside managing its intraday liquidity positions, the bank management should also formulate effective strategies in order to maintain its collateral position at a steady level. They can do so by maintaining a disparity between the burdened and unburdened assets. They should constantly adhere to scrutinizing the legal body and physical location where the collateral has been held and also, should endeavour to outline the ways in which the collateral can be mobilized, in an orderly and timely manner (RBI, 2012). Stress testing can also be conducted by the bank management on regular basis, under different kinds of short-term and prolonged market-wide stress situations, which are specific to certain financial institutions (Saunders and Schumacher, 2000). This will enable the bank to recognize the sources of possible liquidity stress as well as to make sure that their stress exposure level is in correlation with the enunciated liquidity risk tolerance level. They should utilize the outcomes of these stress tests, so as to be able to alter its liquidity risk management strategies, action plans, policies and positions accordingly, thereby laying down effective and efficient contingency plans. The bank can also have a formal backup funding plan, which will clearly set forth the strategies directed towards addressing liquidity deficits, in case of emergency. The contingency funding plan should clearly delineate the policies that will cater to manage a variety of stressful environments and alongside that, establish a clear line of responsibility, which would include clear invocation and acceleration processes (Campello, et al., 2011). The management needs to test and update these procedures at even intervals, in order to ensure that they are robust in terms of their operations. Lastly, the bank must maintain a strong cushion of high quality unburdened liquid assets, that could be held as an insurance against a broad range of liquidity stress scenarios, including those situations which involve the loss or impairment of secured as well as unsecured funding sources. There should not be any type of legal, operational or regulatory restrictions, as far as using these assets to raise funds is concerned (RBI, 2012).   Reference List Arif, A. and Anees, A. N. 2012. Liquidity risk and performance of banking system. Journal of Financial Regulation and Compliance, 20(2), pp. 182-195. Bouwman, C. H. S., 2013. Liquidity: how banks create it and how it should be regulated. [pdf] Wharton Available at: [Accessed: 22 January 2014]. Campello, M., Giambona, E., Graham, J. R. and Harvey, C. R., 2011. Liquidity management and corporate investment during a financial crisis. Review of Financial Studies, 24, pp. 1944-1979. RBI, 2012. Liquidity risk management by banks. [online] Available at: [Accessed: 22 January 2014]. Repullo, R., 2004. Capital requirements, market power, and risk-taking in banking. Journal of Financial Intermediation, 13, pp. 156-182. Saunders, A. and Schumacher, L., 2000. The determinants of bank interest rate margins: An international study. Journal of International Money and Finance, 19, pp. 813-832. Shin, H., 2009. Reflections on Northern Rock: The bank run that heralded the global financial crisis. Journal of Economic Perspectives, 23(1), pp. 101-119. Varotto, S., 2011. Liquidity risk, credit risk, market risk and bank capital. International Journal of Managerial Finance, 7(2), pp. 134-152. Wang, C., 2013. Bailouts and Bank Runs: Theory and Evidence from TARP. European Economic Review, 64, pp. 169-180. Read More