Liquidity Risk Management - Coursework Example

Liquidity Risk Introduction Liquidity risk is the type of risk which cannot be dealt with in swift fashion. This risk is mainly accrued on the asset and securities which can prevent market loss. This type of risk can be segmented as funding liquidity risk and market liquidity risk. Both the segments are used to measure the liquidity risk. The in-depth study on the market liquidity shows that the companies cannot sell the relative assets unless or until there is huge deficit of liquidity in the market. The primary downturn of this strategy might be the result of having widened bid spread or having explicit liquidity reserve of the companies. On the other side, the market liquidity depends on the calculation of value risk and the length of holding period. So, the risk liability is attached with the issue of funding liquidity which may vary in the case of vast range of transaction (Fight, 421). The risk of liquidity tends to be managed, when market, credit and other risks are considered to be additional. There are several types of risk resolving techniques. These all are incorporated with the life of initial bank risk. The Federal Reserve System provided a banking risk framework designed by six factors. These include, reputational and liquidity risk, legal risks, market risks, credit risks. The structures of risk management are thus reviewed, making use of these risk categories. The supervision group is concerned with the liquidity risk fund, continue the preventive action against the other emerging risk and follow the current risk. All this preventive actions are fixed on revelation by majority of Federal Reserve banks. This process tends to figure on a continuous basis, and as a result, measures to counter the existence of so many opportunities may result to risk (Morrison, 245). Financial Risk The financial risk is related with the possibilities of losing money of shareholder. On the other word, the investors did not have enough return on their investment in the company. This type of situation arises when the cash flow of the company proves inadequate to meet all the financial obligation of the company. At the time of insolvency, the creditors or lenders will be repaid before the shareholder of the company. This is applicable when a company concentrates on using the debt finance. This type of risk is also involved when the corporation or the Government unable to repay the bonds. This leads to loss of money of the bondholder. There are different types of financial risk involved with the company which are discussed as follows: Exchange Rate Risk: There is a common definition of exchange rate risk which is mostly related with effect of unexpected exchange rate changes on the value of the firm. There are mainly two types of losses included in the exchange rate risks i.e. direct loss and indirect loss. Direct loss is a result of unheeded exposure whereas indirect loss occurs in firm’s cash flow, assets & Liabilities, stock market, net profit value when exchange rate fluctuates. There are mainly three types of exchange rate risks i.e. Transaction risk, translation risk, economic risk. Exchange Rate Risk Measurement After defining the different types of exchange rates, it is very important to measure the exchange rates. It is a part of the company’s risk management decision. Currency risk measurement is no doubt a difficult task. It is part of the company’s risk management decision. Currency risk measurement is no doubt a difficult task to compare with the translation and economic risk. It is essential to properly manage the exchange rate risk. The managers need to decide whether to hedge or not to hedge these risks. International finance suggests the appropriate strategy to deal with the hedging techniques of different types of exchange rate risks. Hedging strategy is important to handle the exchange rate risk. In order to hedge the transaction risk tactically it is necessary to preserve the cash flow and earnings, which depends on the company’s treasury view. Translation risk crops up when the company handles the finance processes in an infrequent and non systematic way. Most of the companies ignore the force of possible abrupt currency to handle this type of risk. The company also tries to manage short term foreign exposures like valuation of foreign subsidiaries, restructuring the debt structure, international investments in a short duration of time. Net balance sheet exposures are super method taken by present corporate manager to overcome the translation of currency risk of a subsidiary’s value. Translation Risk The translation exchange is basically related with balance sheet exchange rate risk which affects in form when the multinational companies evaluate the foreign subsidiary company. This type of risk is also applicable when the company consolidates a foreign subsidiary company. Translation risk for a foreign supplementary is usually considered by the revelation of net assets (assets less liabilities) to potential movements of exchange rate. The transactional risk not only affects balance sheet but also affects the financial statement at the end of the period exchange rate and average exchange rate. Economic Risk: The source of economic risk primarily relates with the present value of future operating cash flow movements. Economic risk affects the exchange rate changes on revenues and operating expenses. Transaction Risk: Transaction risk is primarily related with cash flow risk. The exchange rate fluctuates with the transactional account exposure. The transactional account exposure relates with receivable from export contracts and payable from import contracts and redemption of share dividends. So it is one type of transaction exchange risk (Nicholas, 259). Foreign Direct Investment (FDI) The business network of multinational companies is situated throughout the world which denotes the involvements of the organizations in Foreign Direct Investment (FDI). Portfolio investment and foreign direct investment (FDI) are mainly related with this type of risk. The country and political risk included with the FDI is level of degree to which company’s value is threatened by the different types of political activities. Another risk including with the FDI, are associated with the fluctuation of the value of the companies (Subsidiary) because of uncertainty about political or policy changes. Bank Risk The bank risk related with the randomness in cash flow which can occur from unpredictable contingency. The banking risk can be identified through the profitability analysis, business cycle analysis. There are number of uncertainties like financial crisis, inflations, and unemployment wars etc that influence the banking risk. This type of risk is primarily variable in nature. The qualitative asset transformation influence to increase the risk which is reflected in the company balance sheet. The risk can be discussed as following ways: Credit Risk The credit risk is related with the loss of a financial reward or loss of principal from borrowers. In this case, the borrowers meet a contractual obligation or fail to repay the loan amount from bank. The primary source of this type of risk is expectation from the borrowers about the future cash flow of the bank for the purpose of paying the debt. Due to the assumption of the credit risk, the investors are compensated by issuer of a debt obligation interest or payment from borrowers. The potential return on investment is closely related with the credit risk. In this risk, it is notified that perceived credit risk is correlated with the yields on bonds. Interest rate Risk The absolute change of the interest rate is the important cause risk in investment's value. The other interest rate relationship or the shape of the yield curve influences the spread between two rates. The changes of interest rate affect the other securities of banking in an inverse way that reduces the diversifying or hedging. Generally the banking industry reduces the rate by investing in the fixed income securities whose maturity period is different. Market Risk The overall performance of the financial market is affected by the perception and experience of the in the market. This risk is also known as systematic risk because it can be controlled by the management. The diversification strategy can not eliminate this type of risk. The declining trend of whole market is the major threat of this type of risk. Other sources of market risk include changes in interest rates and terrorist attacks recessions and political turmoil. Liquidity Risk The lack of marketability of an investment is main stream of this risk. This type of risk minimizes or prevents the loss by reducing the rate of sell and purchase. The large price movements and wide bid ask spread is reflected in this type of risk. Generally, it reflects upward to downward trend. Here larger liquidity risk indicates smaller the size of the security or its issuer (Choudhry, 123). Country and Political Risk There are mainly two types of country and political risks that can be pointed out in the in financial risk i.e. home country risk and host country risk. Home country risk includes required divestment, licensing requirements, change in tax rate for foreign income, risk of transfer prices and sanction. Home country risk affects the textile company by restricting trade and investment activities. It is very difficult to formulate the corporate strategy because of home country risk. This type of risk also effects by technology restriction to provide the national security. On the other hand host country policy risk includes risk of taxation, foreign exchange control, price control, equity dilution, forces JV and expropriation and nationalization. The effect is to face lots of problem in strategy design. Each and every company has some certain strategies to overcome this type of risk. To overcome the political and country risk of the home country the company firstly, detailed analysis the trade climate of UK. Secondly, the company point out the investment attitude of the investors of UK. Finally, the textile giant is forced to divestment to ignore divestment problem. On the other hand to overcome the host country political risk the company applies the Macro Approach. The approach denotes the aggregation of subjective assessments by a penal of experts on different types of economic, social and political factors (Jaffee, 472). Basel Norms The rules and regulation of Basel is mainly applicable for the banking sector. The main purpose of this accord is to reduce the operational risk as well as exposing the operational market risk. The credit risk is a big threat in the banking sector which is reduced by this accord. According to finance theory, when the shareholder value is increased, then the financial institutions and bank should take the positive move toward the project. The financial theory also explains that the relevance of the bank risk. The Basel norms help the manager of the business especially in financial institutions, to maximize the wealth of the shareholders. This process is don through the facilitating the operational process with in minimum cost. This mechanism divided the banking capital structure into different parts which facilitates the whole operation. Real Estate Crisis In US, the real estate crisis is a big problem for the economy. In this case, most of the religion of the US housing market is affected by the economic bubble and housing bubble. The erupted real estate crisis is much similar as the economic crisis. In this time most of the US bank lending the money as house loan to the person which is a big cause of credit crunch. The previous research shows that, in the first quarter of 2006, the price of real estate peaked at the extreme heights. The primary cause of bursting housing babble is excessive credit crunch of US banks (Choudhry, 256). Lehman brothers Lehman Brothers was a financial services organization and one of the top players of the financial sector in the world stage. Lehman Brother was ranked fourth among the world’s largest investment banks with the top three players being Goldman Sachs, Merrill Lynch and Morgan Stanley. The example of Lehman Brother is ideal to consider in explaining the aspect of liquidity risk. The core business of Lehmann Brothers included financial services in investment banking, investment management trading of fixed income securities and equity, private banking and private equity. In 2008, Lehmann Brothers filed for Bankruptcy protection which was aggravated due to fall in prices of its stocks and devaluation of its assets as reported by the credit rating agencies. The collapse of Lehmann Brother is a significant episode in the US investment and financial market scenario. The following situation can be described to indicate the reasons behind the vulnerability of Lehmann Brothers to its liquidity risk exposure which ultimately led to its downfall. The year 2007 was marked by financial crisis in the US financial market mainly due to the increased subprime losses. The subprime market is a secondary market of investment in securities apart from the primary investment market. Investments were made by the companies in the subprime market looking to achieve their short goals in terms of servicing their short term liabilities. The investments made by the companies in the subprime market had lesser credit regulations and norms and also demanded for lesser documentations and hence was very risk. However with a view of gaining through investment in short term assets, the companies overlooked the risk of defaults as strict appraisals of those investments were bypassed. The inevitable outcome was the devaluation of the investments and assets in the subprime market which led to the liquidity crunch of the companies and drastic fall in their share prices. Due to this sub-prime loss, the companies had to reduce their proportion of long term assets to meet the short term liabilities. When this situation fell out of control which began due to the inability to mitigate the short term liquidity risk, the companies were forced to declare bankruptcy and subsequent liquidation of assets. Lehmann Brothers who lad a huge share of investment in the subprime market mainly due to its core area of business in financial services sector was badly hit in terms of liquidity risk arising out of the crisis and not being able to justify its short term liquid position in the financial market. The mortgages which were held as underlying securities of sub-prime loans granted by the company were devalued drastically leading to the devaluation of the securities and hence leading to the default of the financial loans. This resulted in liquidity crunch in Lehmann Brothers. Also Lehmann Brothers was unable to sell lower rated bonds or were ineffective in deciding to hold such lower rated bonds. In the first quarter of 2008 itself, the liquidity risk affected Lehmann Brothers so badly that almost 73% of the value of its stock declined. Due to unprecedented and further aggravation of the scenario, Lehmann Brothers had to reduce 6% of its work force and the deadline for its existence was extended till September 2008. The investor’s confidence on Lehmann brother eroded drastically and the US government also had no plans for assisting the financial services giant. The president of Federal Reserve Bank of New York on 13th September 2008 called a meeting to discuss on the future of Lehmann Brothers and possible liquidation of its assets in case of emergency. Ultimately due to its position of heavy losses, Lehmann Brothers had to conduct talks for its acquisition and finally declared bankruptcy in September 2008. The fallout of Lehmann Brothers due to liquidity risk led to the acquisition of its portion of $1.75 billion including most of its business in North America by the Barclays Bank. The Asian business of $225 million and parts of the European business was acquired by Nomura Holdings which is a top brokerage firm in Japan. Liquidity risk: Europe v/s USA and Asia In this section, a discussion would be done on the liquidity crisis in Europe as compared to the other parts of the world like USA and Asia. European crisis The monetary system in Europe is such that the European banks need to constantly lend each other not only to produce loans for new financing but also to acquire debts to meet the short term demands. The inter-bank market forms the blood stream of European economy. The European banks like that of Greece, Spain, Italy has large share of sovereign debts. Due to the financial crisis that has started in 2008, the value of these sovereign debts has largely declined. This has created liquidity risk and positions of insolvency to the Europeans banks which comprise the core of financial and monetary system in Europe (Ruozi and Ferrari, p.3). Thus the European banks are no more able to exchange currencies with foreign banks in USA or Asia and have set themselves to limited transactions. Although the capital of the European banks may not be a point of concern, the net liquid position or the net operating cash flow of the European banks is facing an unprecedented crisis. Considering the Greek banks, their proportions of sovereign debts have left them in a position of financial crisis due to devaluation of debts and subsequent liquidity crunch. Due to shortage of liquidity, the amount of debt is increasing above the capital holdings which expose the European banks to liquidity risk. The French banks are on the other maintaining a relatively liquid position. The monetary system of Europe is such that the European Central Bank is in charge of controlling inflation and the responsibility of restoring financial health of a European nation’s economy is bestowed on the country’s central government (Berend and Berend, p.65). The central bank of the country is not permitted to print notes which can be done only by the European Central Bank headquartered in Germany. This has left European banks in a spot of bother in the wake of liquidity crisis and reduced lending and borrowing. Post world war, European countries like France has a public debt of 86% of GDP. The annual funding requirement of France is 20% of GDP. Other European countries like Belgium, Italy, Spain and Portugal has an annual funding requirement of 20-25% of their respective GDP. The liquidity crisis of Euro zone countries can be divided into two parts. While countries like Greece and Portugal get funding from the European Union and the International Monetary Fund, Spain and Italy are funded by financial markets where the sovereign banks are allowed to purchases repo from the European Central Bank for debt funding. Thus funding these countries by way of public financing for Greece and Portugal and lending to government treasuries of Spain and Italy to enable them purchase repo agreements from European Central Bank can help in countering the liquidity crisis. US crisis The monetary policy in USA is determined by the role of country’s central bank and other regulatory authorities who ensure the rate of growth of monetary supply. USA has an annual funding requirement of 30% of its GDP. This has been helped by the government’s policy of stopping the sales of 30 year T-bond in order shorten the average time of debt. The liquidity crisis in USA started with the subprime crisis in 2008 which melted down into a global recession. This happened due to liquidity crunch in the countries economy and acceptance of US dollar as a standard currency all over the world. The subprime crisis in US was mainly due to falling prices of the underlying mortgage securities market and subsequent devaluation of the stocks and assets of US companies. World leaders like Lehmann Brothers had to shut down their operation in the face of quick erosion of their asset value. Funding available due to take over of companies hit by financial crisis, government funding as well as expansion of companies overseas has steadied the liquidity crisis situation in US (Allen, p.118). Asian crisis The Asian liquidity crisis of 1997-98 can be attributed to the illiquidity in the international stage. This illiquidity occurred because the short term liabilities of Asian countries like Thailand Indonesia, Malaysia and Korea in term of foreign currencies were more than their access to foreign currency amounts. This led to the plunge in value of the assets of Asian companies. As a result of this, the current liquid positions of the Asian banks were badly hit. The crisis in Asia was aggravated with the lowering of foreign currency exchange rates. Sixteen Indonesian banks closed down and nineteen out of thirty merchant banks of Korea closed their operation. Korea however underwent a transformation through restructuring of its liabilities. The major factors of the Asian crisis can be attributed to pre-mature financial liberalization, low reserve requirements of banks leading to lesser available liquidity in their hands. Also short term liability positions in the foreign markets increased rapidly, increased foreign currency debt in Euro or Yen. This liquidity crisis in Asia has led to adoption of policies by Asian countries to limit the exposure of their foreign currency liabilities, foreign debts as well as reduce the percentage of investment in foreign currency denominated assets (Chatterji and Gangopadhyay, p.62). Monetary policy - controlling liquidity risk Liquidity can be described in micro-economic perspective as the ability to sell an asset in the quickest time and least cost. In macro-economic perspective liquidity is explained as a medium of exchange of goods and service. Money is the most liquid form of exchange. Thus monetary policy largely determines the risk of liquidity. The monetary policy of a country is governed by the monetary authorities or central banks of a country to control the flow of money in the economy to ensure steady growth develop financial health and control inflation. The government adopts expansionary monetary policies to increase the supply of money in condition of liquidity risk. In order to counter liquidity risk, the government lowers the interest rates to reduce deposits with the banks and increase the supply of money in the economy. In order to avoid deterioration of asset values as well as to control inflation, the government adopted contraction of monetary policy. This policy involves raising the interest rates and increasing deposits in the system to counter the devaluation of assets as well reduce inflation. In cases of recession like in the US and Asia, the liquidity risk can be mitigated by the adoption of monetary policy measures. Apart from this, controlling liquidity risk requires thorough review of the government policies on investment, public financing, emergency funding, etc. The requirements of debt need to be funded by appropriated monetary authorities for controlling liquidity risk. This situation is applicable for European crisis where the banks are dependent on the inter-bank market for lending as well as borrowing. Conclusion Liquidity risk arises due to the uncertainty that an organization is exposed when it is unable to sell its assets because of the liquidity crunch in the market or when the short term liabilities of an organization exceeds the valuation of its short term assets. When considerable investment in short term assets are devalued to more than 90% of its values as the situation turned out in case of Lehmann Brothers, the company due to shortage of liquidity and burden of debt is forced to declare bankruptcy. The liquidity risk in different parts of the world has its own characteristics. The liquidity risk in Euro zone is mainly due to decline of exchange of debts in the inter-bank market which is the lifeline in the region. The European Central Bank based at Frankfurt is responsible for controlling inflation whereas the financial health restoration is the responsibility of the individual central banks. The liquidity risk in US was due to the subprime market loss and devaluation of US mortgage securities market. The subprime crisis melted down to a global recession. The Asian crisis was due to the increased exposure in foreign market investment, foreign debts and fall in the foreign currency exchange rates (Mishkin, p.350). Works cited Choudhry, Moorad. An introduction to banking liquidity risk and asset-liability management. Chichester, U.K.: John Wiley & Sons, 2011. Print. Jaffee, Dwight M.. The Swedish real estate crisis. Berkeley: Institute of Business and Economic Research, University of California at Berkeley, Center for Real Estate and Urban Economics, 2010. Print. Fight, Andrew. Understanding international bank risk. Chichester, West Sussex, England: John Wiley & Sons, 2009. Print. Morrison, George R.. Liquidity preferences of commercial banks,. Chicago: University of Chicago Press, 2010. Print. Narusis, Romanas. Liquidity risk. Odense: Syddansk Universitet, 2008. Print. Nicholas, James C.. State regulation/housing prices. New Brunswick, N.J.: Center for Urban Policy Research, 2012. Print. Ruozi, R. and Ferrari, P. Liquidity Risk Management in Banks: Economic and Regulatory Issues. Germany: Springer, 2013. Print. Berend, I. T. and Berend, T. I. Europe in Crisis: Bolt from the Blue?. UK: Routledge, 2012. Print. Allen, R. E. Financial Crises and Recession in the Global Economy. Great Britain: Edward Elgar Publishing, 1999. Print. Chatterji, M. and Gangopadhyay, P. Economic Globalization In Asia. England: Ashgate Publishing, Ltd., 2005. Print. Mishkin, F. S. Monetary Policy Strategy. USA: MIT Press, 2007. Print. Read More