Finance Institution Management - Essay Example

Finance Institution Management Student’s Name: Institutional Affiliation: University: Finance Institution Management The analysis of the demand of money has traditionally dealt with the on-balance sheet liquidity independently or differently from the off-balance sheet liquidity. However, if the two kinds of liquidity are substitutes or even if the rates of interest depend on the total ‘liquidity’ demand, then the analysis of the demand of money independently from the demand of off-sheet balance sheet liquidity will result to inappropriate guidelines for the monetary policy. The discussions about monetary targeting and monetary policy have been restricted to liquidity forms appearing on the financial institution’s balance sheets. A bigger part of the debate has been about the types of the institution’s liabilities that should be properly regarded as money, and thus which are believed to represent the proper target for the monetary policy. However, it is interesting that there has been paid very little to the monetary significance of the institution’s contingent liabilities in form of the off balance sheet credit facilities. Nevertheless, these facilities offer a means or standard of exchange capacity and also represent a liquidity replacement for the on-balance sheet money. Individuals together with firms seem to determine their demand for the off-balance sheet and on-balance sheet liquidity jointly, whereby one might be a substitute of the other (Knight & Satchell, 2003). This actually has several significant implications for the determination of interest rate and the monetary policy. Nonetheless, to the level that the adjustment of interest rate eventually clears a ‘liquidity’ market, we find that the sustainability of the off and on balance sheet aggregates greatly weakens the relationship between rates of interest, money and the other variables of concern to the policymakers. However, if this conception is accurate, then the monetary authorities must be aiming or targeting, or even at least watching the total liquidity, which include the unexploited off balance sheet credit facilities (Knight & Satchell, 2003). This aggregate’s short-term discretionary control might appear to be quite tough, however, considering the tendency of the off-balance sheet liquidity to the countervailing of changes in the ‘money’ including the ones that are produced by monetary ‘surprises’ or even the unexpected shocks in the monetary policy. It might be essential to address the matter of regulation of the off-balance sheet liquidity. Nevertheless, similar debates over the bank liabilities and the on-balance sheet money usually involve trade-offs between micro and macro considerations. However, the former include discussions for regulation for the purpose of improving the control of money as well as the prevention of the macroeconomic instability. The micro considerations may dictate the opposition to more control so that it can attain efficiency in the banking operations together with credit allocation, contingent balance sheet activities or even the off-balance sheet liquidity (Hachmeister, 2007). Liquidity Risk This is the current and probable risk to capital or earnings that arise from the inability of a bank to meet its compulsions or requirements when they come due without having to incur deplorable loses. It includes it inability to sufficiently manage unplanned falls or even changes in the funding sources. It can also arise from the failure to address or recognize the changes in the market conditions that impact the ability of liquidating assets quickly and also with small loss in value (Hachmeister, 2007). Liquidity Risk Sources Liquidity risk arises from the nature of the business of banking, from the banks exogenous macro factors, and also from the operational and financing policies that are internal to the banking company. Banks offer maturity transformation. The taking of deposits that can be called on demand or even that averagely has shorter maturity of financing contracts that they sell. Whereas maturity offers liquidity insurance to those depositing their money, which is valued by them, we find that it exposes the financial institutions to the liquidity risk themselves. Nonetheless, since banks specialize on the maturity transformation that they take full control and care for, in order to match their cash outflows and inflows for the purpose of addressing the liquidity risk that they experience (Culp, 2001). However, the mismatch of maturity at a particular time is not only the liquidity risk’s source. This kind of risk can always emerge from several directions and its pinch is dependent on different factors. Its sources on the side of assets is dependent on the level of the bank’s inability to convert into cast, its assets without experiencing loss at the time of need, and on the side of liabilities, it emerges from the unexpected recall of the deposits. They can further be broken down into the following exogenous and behavioral sources: 1. Improper judgment or even the bank’s complacement attitude towards the timing of its cash out-flows and in-flows. 2. Unexpected change in the capital cost or even the availability of funding. 3. Unusual behavior of the financial markets under stress. 4. The range of assumptions that are used in the prediction of cash flows. 5. Activation of risk by secondary sources like: i. Failure of business strategy ii. Failure of corporate governance iii. Modeling assumptions iv. Accusations and merger policy 6. Settlement and payments system’s breakdown 7. Macroeconomic imbalances To the level that the cash flows’ timing can be predicted the control of the liquidity risk can be done. However, the banks are increasingly getting involved in the provision of contingent liquidity and credit services to the borrowers whose major source of financing lies somewhere else in the capital markets and who only go to the banks during contingencies. Therefore, the judgment of the bank on the cash out-flows can end up being inappropriate, thus the first major source of the liquidity risk. The banks’ involvement in the derivative products with the collateral requirements further increases the chances of large amounts of the contingent calls for security or cash. Another source of liquidity risk comes from the unexpected difference in the assumed and realized funding availability, its assets’ marketability or their use as collateral in the raising of money faster, and the amount of haircut expected. This can occur as a result of the general causes to the sector of banking or even specific to the bank (Culp, 2001). Another factor source, the capital markets’ behavior in stressed situations, lies outside the bank’s control but have implications for the banks’ liquidity. First, undesirable movements within the capital markets greatly affect the availability of money to the bank if it wishes to raise it via them. Second, growing banks’ reliance on the wholesale markets instead of small depositors impacts the composition of the reliance by the banks on whole sale markets rather than small depositors affects the composition of risk sensitive market confidence depositors in the bank’s depositor pool (Hachmeister, 2007). These depositors quickly move their finances away from the bank when they sense the initial signs of problems, hence increasing the possibility of a ‘run’ on the liquidity or bank problem. Another factor which is not apparently a cause but determines the readiness of the bank in dealing with the liquidity shocks; the larger the number of instances and the range of presumptions for which a bank has its stress assessed against the liquidity crisis, the greater the chances of smooth management of risk (Culp, 2001). Liquidity Risk Management In the management of liquidity risk, it is important for the financial institutions to only rely on the simple static maturity ladders and give a wide range of indications on more tools that should be generally available. For instance, regulators have issued statements like: The analysis of liquidity should be done by utilizing various what-if scenarios. Financial institutions should try defining the assumptions or postulations on the anticipated future behavior of the liabilities and assets in the building up of their maturity ladders. Liquidity exposures must be the subject to the sporadic stress testing to examine the effect of improbable undesirable events on the stability of the institution. All the financial institution should have contingency plans in place that enable them to quickly deal with the unexpected liquidity shortages. Unavailability of standardized quantitative methods to the liquidity risk partly relates to its nature. It is difficult to quantify liquidity risk in a single number that represents a correct, all-inclusive view of it. There are some trials that have been made via ratios, even though it has not become a standardized approach, as in the case of the comparison of different requirements that have been put by the local supervisors (Hachmeister, 2007). Beyond static maturity ladder The fundamental liquidity risk management tool has generally been the cash flow projections’ static maturity ladder. In order to be able to create the cash flow maturity ladder, distributions of future cash outflows and inflows are done within the time buckets in accordance with their maturity. However, the periods of time buckets generally begin at one day for the shortest period and then extend slowly over the subsequent periods. The time buckets’ granularity, particularly in the shortest term, is very essential. Liquidity problems might come up abruptly, so that the ability of a bank to be in a position of matching all it immediate commitments is crucial for stability. Cash flow’s intra-day information can also be fundamental, specifically for the institutions that might experience large fluctuations in cash due to situations like settlement or payment services given to the other intermediaries. The analysis of future cash flows is then done on a daily balance basis and also on a cumulative basis (Crockford, 1986). Nevertheless, imbalances provide an understanding of the manner in which the cash exposure of a bank is expected to behave in future. Companies usually create internal limits on the basis of these figures, putting a restraint on the treasury about exposure to the maturity mismatches. Furthermore, some regulators are specific on the limit kinds that should be set. The maturity ladder’s reliability is a direct purpose or function of the reliability of the figures, which are put into it, but even so, the implications for cash projections are not in any way straightforward. Several issues should be addressed, and in most instances depend on the quantitative tools that are used for effective evaluation in the context of liquidity risk. Such issues include: the upgrading of information systems, coping with events that are third-party initiated, understanding the effects of collateralized securities, stress tests for the collateralized securities and creation of projections for derivatives (Culp, 2001). Organizational Best Practices The most important requirement for efficient risk management, that is both in the crisis and normal situations, is a meticulous knowledge at the senior level of management of a company’s business together with its related risks. The funding of liquidity problems can not only come up from the easily available or present sources that are internal to the company, but also from the outside events that are not related to the problems or actions on the part of the firm. Signs of an impending liquidity crisis can even be realized from outside of the conventional borders of the business of the firm. A good information system as well as a very strong intelligence capability is essential to ensuring that the company maintains inclusive risk awareness at the enterprise level (Bhaduri & Youn, 2007). Furthermore, strategies for adaptation or coping with emergencies are based on the everyday operations. For example, it is important that an institution work very hard in order to be in a position of maintaining a wide business relationships framework in the financial platform and ensure improvement of its market status. It is also good to ensure maintenance of a minimum level of utilization of facility, for the purpose of avoiding the possibility that sporadic utilization will offer counterparties the picture that a company is experiencing liquidity issues (Carey & Stulz, 2006). Managing liquidity risk under the context of a crisis does not involve a trade-off between underperformance and risk, which are in some instances very difficult to optimize. Given the low possibility of occurrence of the funding emergencies, experiencing high costs for the widespread protections could appear to be unreasonable. Companies that had never addressed this matter properly experienced difficult times in the subprime crisis. Management of the trade-off is a critical challenge for the management team (Hachmeister, 2007). The issues of the management of liquidity risk might also lead to very critical decisions concerning business strategies. For example, a company might make a conclusion that it is vulnerable to deplorable liquidity risks as a result of too much of concentration and might therefore take actions for the purpose of increasing diversification. Best decisions require full knowledge of the risk at the top level of management, and this consequently requires that risk evaluation remain independent. References Bhaduri, R. & Youn, J. (2007). Hedging Liquidity Risk. Journal of Alternative Investments, Winter 2007. Carey, M. & Stulz, R. (2006). Risks of Financial Institutions. Chicago: NBER & University of Chicago Press. Crockford, N. (1986). An Introduction to Risk Management. London: Woodhead-Faulkner. Culp, C. (2001). The Risk Management Process. New York, NY: Wiley Finance. Hachmeister, A. (2007). Informed Traders as Liquidity Providers. Wiesbaden: DUV. Knight, J. & Satchell, S. (2003). Forecasting Volatility in the Financial Markets. UK: Butterworth-Heinemann. . Read More