Types of Liquidity Ratios - Report Example

Operation Banking Liquidity ratios have a strong bearing on the direction of the company from the past, to predict the future financial performance in the company. They are static ratios calculated from the company’s balance sheet. According to Palmaratha (2010, 397) the use of the liquidity ratio has been taken to presuppose that the past performance in the company could be a strong indicator to the future. However, this was later found not to be the case always as banks failed due to problems triggered by the same liquidity ratios in a dynamic market. Palmaratha (2010, 397) gives an example of the risk amounting to the use of liquidity ratios to be the failure of Southeast Bank; a large regional bank in the U.S, that employed over 30 liquidity ratios to manage the liquidity in the bank, leading to its failure in 1991. This led to better methods of measuring and managing liquidity. There are two types of liquidity ratios as explained by Palmaratha (2010, 397).funding liquidity risk and market liquidity risk. Funding liquidity is measured by the ability of the bank to meet the expected and unexpected future and present cash flows, as well as the collateral needs without affecting the daily operation of the firm or company. Market liquidity risk on the other hand is measured by the ability of the company to offset a specific position at the market price due to inadequate market disruptions or market depths. The two risks might inmost cases be dependent on one another in that, while investors demand higher compensation for the increased risks, the need for funding liquidity would certainly rise since the liquidity prevailing in the market would make it difficult to dispose of assets in order to raise the required funds. To manage the liquidity risk as Gugliemo (2008) explained would entail defining and indentifying how much liquidity is available in the company. This includes the contingency, operational and reserve liquidity. Afterwards the company has to establish the accessibility of the liquidity as well as the relative costs involved. Gugliemo further explained that, determining the needed operational liquidity in the short term as well long term basis would work well in managing the liquidity risk. The determination of the possible changes in the market conditions and the expected changes in the liquidity needs and cash availability are also strategic methods of managing the liquidity risk in the company. The presence of sufficiently early warning systems that would allow a strategic action prior to the actual problem would be of importance in mitigating and managing the liquidity risks. Gugliemo (2008) further explained the importance of process and controls that would ensure successful execution of action plans in managing the liquidity risks. Measurement and effective management of interest rate risks (IRR) calls for the effective identification and quantifying of the risk. There are various tools that have been use to measure the interest rate risk as well as to hedge them to effectively reduce the adverse impacts on the bank balance sheet as Bhole (2009, 317) explained. The instruments mostly used for the measurement of the interest rate risk are the maturity gap, simulation modeling, duration and modified duration as well as value at risk (Bhole, 2009:317). Maturity gap analysis is the simplest technique in analyzing and calculating IRR exposure. The maturity gap is used to measure the dfirection and extent of asset liability deviation. The maturity gap is in most case computed on assets and liabilities having a different maturity period in a specific time frame. Bhole further argued that the gap is an assessment on the pricing gap between the interest gained by banks on the assets and the interest paid on its liabilities over a given time frame. It has been used as a tool to highlight the net interest income exposure of a bank as a response to the prospective changes in the interest rates in different maturity buckets. A positive gap would indicate an excess of repriced assets over the liabilities while a negative gap indicates that the liabilities have been repriced over the assets in the company (Bhole, 2009: 317). Therefore in the measurement of IRR, a gap indicates the difference between the gap value of the rate sensitive assets as well as the rate sensitive liabilities. In a case where there is a change in the interest rate, it would be therefore possible to indentify and access the impact of such changes in the net interest income of the bank. The interest rate models have a direct value effect as Bhole further explained. The weakness in the interest rate model would be the reason that, it only takes into account the book value of assets and liabilities and this leads to an ignorance of the market values of the same. It is therefore a partial measure and not a compete indicator of the true interest rate exposure to the bank. The maturity gap model has to be aligned with the various phases of the business cycle, sine the variability of the interest rate is essential to the phases of a business cycle. The duration model on the other hand as Bhole (2009, 318) explained matches the duration of the assets and the liabilities instead of comparing the repricing dates, and has been indentified to be a better tool to cushion the business against the effects of IRR. It involves the measure of the percentage change in the economic value of the portfolio that would be expected to occur due to respective changes in the interest rates. The duration gap measurement however presents a more daunting task compared to the normal gap. The difference between duration of assets DA and the duration of liabilities, DL is the net duration of the bank. In case the DA> DL, then a decline in the market rates would lead to a declined interest rates and hence an increase on the market value of equity (MVE). It is therefore possible to immunize the interest spread of the bank while using the duration model compared to the previous model since it represents what actually occurs in the real market rather than a model on books. Operational risks are risks that any financial institutions would be threatened with in the line of business which would include e fraud, system failure due to malice damage or system breakdown or procedural inadequacy. In the current market, banks and other financial institutions have put up measures that have led to the over reliance with information technology and as Choudhry (2002, 272) explained repo trading systems which are more advanced and sophisticated systems. The modern repo systems are used in the entire office in the organization, starting from the front office to the back office, middle office risk management, and accounting and other respective departments in the banking system. Such an extensively used system has a great threat potential when interfered with due to malice of system breakdown in the company. Choudhry (2002, 272) explained that in order to reduce cases of operational risk, it requires the formation of operating procedures and communication to all the users in the company. Moreover, Choudhry argued that regular reconciliation might be carried out to the data coming for the middle, front and back offices and involving the counterparty standing data. Other forms of operational risks might be effectively minimized through application of formal procedures as well as monitoring by the risk management, compliance department and internal audit sections. Settlement risks on the other hand are an operational risk also referred to as delivery risk. It might not be unique to report but as Choudhry (2002, 272) explained, it exists to all the capital market trading activities. In repo, the settlement risk might be considered as a risk when counterparty has failed to deliver on its commitment on the due date at opening or closing leg. Therefore in a bank, it might be considered as a case where a bank delivers the stock while the counterparty has not delivered the corresponding cash or stock. It is however a very rare case in developed markets where the banks have to deal with well established counterparties as Choudhry (2002: 272) explained. An example of he above bank fraud operational risks would be the case where the renowned athlete Montgomery was charged with bank fraud together with other accomplishes. A report by Zinser (2006, April 19) indicated that he athlete has been involved in a $5 million bank fraud case with others through counterfeiting or altering of checks. This is an example of many operational risks that threaten the operations of banks and other financial institutions. References Bhole,L. M., 2009. Financial institutions and markets 5E. New Delhi: McGraw Hill. Choudhry, M., 2002. The repo hand book. MA: Butterworth-Heinemann. Gugliemo, M. R., 2008. Managing liquidity risk. [Darling Consulting Group]. Available at [accessed 20th Jan. 2011] Padmalatha, S., 2010. Management of banking and financial services. New Delhi: Dorling Kindersley (India) Pvt. Ltd. Zinnser, L., 2006. Montgomery indicted in a bank fraud case. New York Times, 29 April. Read More