Financial Markets and Risk: Adequate Liquidity - Assignment Example

? Topic: Lecturer: Presentation: Adequate Liquidity Commercial banks need to maintain safety and solvency for them to remain relevant in the financial market. The banks thus need to effectively manage risks which include; credit risks, market risks and operational risks. For a bank to meet its customers and creditors demands, it needs to have adequate liquidity. Liquidity refers to how quickly and cheaply an asset can be converted into cash in order to generate sufficient funds to meet the banks payment obligations in full as they fall due. If the bank assets take a long time to sell or cannot be converted to cash with ease such as fixed assets they are considered to be illiquid. According to Melicher & Norton (2011), there are various factors that contribute to the liquidity of banks. Banks with a strong capital base can be able to effectively absorb risks associated with assets and ensure safety of depositors funds as well as maintain creditor confidence hence if a bank has a high amount of Tier 1 capital, it has a higher liquidity. Adequate liquidity also involves having a strong bank positive image. If depositors or creditors view the company negatively or suspect it does not have a sound liquidity, they will shun away from the bank and the effect is felt systematically throughout the financial market. The senior managers thus must devise efficient ways of managing liquidity risks so as to gain confidence from creditors and depositors. This can be achieved through offering quality customer services and being transparent in its activities by publishing reports. Positive bank image thus contributes to liquidity and vice versa as adequate liquidity ensures banks positive image (Melicher & Norton, 2011). According to Financial Services Authority (2008), asymmetric information can lead to speculation or uncertainty in the financial market regarding the banks creditworthiness and its true worth hence lead to loss in confidence by other banks who can lend it money to settle its debts and maintain liquidity and other creditors and depositors hence transparency is essential. Adequate liquidity also ensures the banks have reduced risk of asset sales at fire-sale prices (FSA, 2007). If a commercial bank wants to meet its obligations and has no assets that can be changed into cash in short time, it may result to selling its illiquid assets which are of high worth at low price leading to an imbalanced balance sheet or solvency. This has the effect of destabilizing the asset market hence influencing asset prices thus the effect is felt in the whole market. Managing liquidity risks and having adequate liquidity prevents this from happening as a bank can take its time to convert the asset to cash without any loss. Maintaining adequate liquidity also ensures the bank does not hold a high stock of liquid assets as this increases its costs of mitigating risks. This may affect the banks competitiveness especially if other banks do not mitigate risk by maintaining high liquid assets hence run at low costs thus attracting depositors. Greuning & Bratanovic (2009:191) observe that adequate liquidity enables banks to “compensate for expected and unexpected balance sheet fluctuations and provide funds for growth”. It is also essential to have adequate liquidity as all financial transactions involve elements of liquidity. Liquidity problems have an effect on the whole financial system hence having adequate liquidity is important in maintaining the safety and solvency of commercial banks. Capital Adequacy The availability of capital as well as its costs is essential in determining the soundness and safety of commercial banks (Greuning & Bratanovic, 2009). Capital adequacy standard is stipulated by Basel I and Basel II capital accords whereby commercial banks are supposed to ensure adequate amount of capital and reserves is maintained in order to guard the bank against solvency. According to Farid & Salahuddin (2006-2010), all countries are supposed to maintain a minimum regulatory capital of 8% of risk weighted assets that can be used to cover and maintain risks. This is to ensure the banks have adequate capital thus protect the global financial system as well as the depositors. The Bank for International Settlements (BIS) gave capital adequacy requirement based on use of risk weighted assets ranging from 0% for those assets which have less risk such as cash and equivalents and government securities, interbank loans at 20%, mortgage loans at 50% while the riskiest assets such unsecured personal loans and standby letters of credit were assigned a risk weight of 100% (Melicher & Norton, 2011). The capital adequacy requirement was put in place so as to reduce competitiveness in global financial sector and create consistency. It involves assessment of credit risk, market risk and operational risks. This enables the banks to link capital with risk taking behaviour hence avoid solvency. Capital adequacy requires commercial banks to be transparent or maintain market discipline. This enables the shareholders and other stakeholders to have a clear picture of how the bank manages its risks and make informed choices. This in turn forces the banks to manage its risks effectively so as to attract more capital and retain clients. The bank also ensures it has enough capital to cover all the risks and in the process ensure safety and solvency of the bank. It also ensures that banks operate at a set level of risk tolerance (Gallati, 2003). Capital adequacy also ensures that banks do not engage in excessive risk taking as this can have dire consequences as experienced during the recent global financial crisis. This is because the amount of capital set aside as capital adequacy requirement is tied to the amount of risk that the bank undertakes. Capital adequacy requirement thus ensures effective management of market risks and stability in the financial sector (Melicher & Norton, 2011). Availability of enough capital especially capital from owners or Tier 1 capital determines the level of assets that a bank can have. Higher capital than the required minimum enables the bank to acquire more assets hence improves on its liquidity. This in turn ensures safety and solvency of the banks. It also boosts shareholder confidence as they expect return on their investments and if the bank manages its risks effectively more dividends are realised. Stability of the bank is also ensured and cost of capital reduced hence attracting more capital. The banks are able to develop sound risk management policies hence improve the quality of the banks assets and effective management of off-balance- sheet exposures (Greuning & Bratanovic, 2009). Methods Commercial Banks Can Use to Manage Liquidity Effective liquidity risk management ensures the bank can meet its payment obligations as they fall due since many banks borrow short-term funds and lend for long term purposes. A sound bank must be able to manage risks and investment portfolios. According to Fuller (2009), commercial banks can acquire liquidity by borrowing from the central bank and lend it back through the process of bailout. This was manifested during the recent financial crisis when the Bank of England was engaged in massive bailouts by investing shares in the banks. Greuning & Bratanovic (2009) on the other hand argues that expecting the central bank to provide liquidity can lead to loss of confidence for the bank and eventually the whole system. It should only be used as a lender of the last resort to banks which are insolvent. Central banks also manage liquidity by increasing liabilities. This is achieved by increasing short-term borrowing and deposit liabilities. This in turn increases the available capital which can be used to liquidate the bank. Banks borrow funds from the money market or other banks to meet their obligations. Money is thus redistributed between banks enabling banks to raise funds for various periods. To achieve this, the bank should have portrayed a positive image or creditworthiness over time. If other banks or financial institutions perceive one bank as insolvent, they may not lend funds to the bank. The interbank funding is also affected by market conditions. For example, during times of uncertainty like the financial crisis larger banks are unwilling to lend funds to smaller banks (Melicher & Norton, 2011). The central bank sets a minimum liquidity requirement for banks which they comply with. Commercial banks can also get liquidity insurance from the Bank of England to safeguard against liquidity risks by accepting less liquid assets as collateral at a fee in exchange for more liquid assets. Banks under sterling stock regime are required to limit their short term lending volatility by limitation of sterling net outflow for 5days and agree to a sterling stock floor with FSA of 50%. This ensures that the banks have sufficient stock of liquid assets at all times (FSA, 2007: 35). Those under building societies regime hold 3.5% of liabilities in high quality marketable assets which are supposed to extend beyond those held as collaterals by the BoE. Commercial banks also carry out stress tests in order to quantify exposure to possible liquidity stresses (FSA, 2007). This enables the banks to mitigate risks by assessing internal stress as well as market wide stress and off-balance-sheet transactions. The banks are thus required to carry out quantitative and qualitative liquidity reporting hence keeps track of their liquidity profile and manages liquidity effectively. Strategic asset allocation enables the managers to determine optimal policy mix of asset classes’ hence efficient liquidity management. Commercial banks also engage in securitization of assets to get the required funds. This involves use of assets to get loan and turn it into security so as to earn returns. Mortgage backed securities are traded in stock market so as to get short-term funds. Asset management also involves restricting the rate of loan growth such that the available deposit funds can support the loan. This ensures there are no asymmetries on the balance sheet in form of added loan liabilities. Basel I and Basel II Capital Accords The bank of international settlements based in Basel established the minimum level of capital that banks must hold hence ensure capital adequacy across different countries. The minimum regulatory capital determination is based on the riskiness of bank assets. The Basel I accord concentrate on maintaining capital adequacy and manage credit risk, market risk while Basel II capital accord build on Basel I foundations but to a greater extent by inclusion of operational risks and allowing banks to manage risks through internal measures. The two accords aim at aligning regulatory minimum capital with risk (Greuning & Bratanovic, 2009). Assets were assigned weights based on the level of risk they possess. The safest risks were weighted at 0% with the riskiest assets assigned 100%. According to the accords, capital is classified into 3 Tiers. Tier 1 comprises of 4% of risk weighted assets and includes capital generated from owners such as equity shares and retained earnings. It is permanently available. Tier 2 capital is limited to 100% of tier 1 capital and includes; asset revaluation reserves, debt/equity and subordination term debt. Tier 3 capital is 250% of Tier 1 capital allocated to market risks and involves short-term subordinated debt (130). Basel II involves 3 pillars; minimum capital requirements, supervisory review and market discipline. The minimum capital requirements involve credit risk, market risk and operational risks. The credit risk can be calculated using various methods such as; standardized approach, internal ratings approach, and advanced internal ratings based approach. Basel I accord used the standard approach where assets were assigned weights depending on their riskiness. The internal rating based approach enables bank owners to use their own internal models to establish the regulatory requirements. This is due to the fact that the standard approach ignored some risks which eventually rendered the risk managent ineffective or unreliable. This method utilises probality of default, loss given default, exposure at default and maturity of exposure. This method utilises banks historical data of credit portfolio of the bank (Greuning & Bratanovic, 2009: 7). The advanced internal rating based approach uses advanced techniques. This encourages the managers to improve their risk management techniques because advanced techniques result in less capital requirement. The market risk evaluation enables risk managers to determine how much the bank could lose over a certain period and probability. Operations risk management on the other hand, uses standardized approach and reflects the risk of loss due to failure of internal bank processes and systems or as a result of external events. Pillar 2 covers risks that are overlooked in pillar 1 such as liquidity risks and interest rates. Pillar 3 involves disclosure of information to the public so that they can understand the workings of the bank in managing risks. Shareholders entrust their capital to the management of the banks and require returns on their investment and it would interest them to know if the risks are managed properly so as to get higher returns and decide on whether to invest more. Clients also have an interest in risk management activities of banks to ensure safety of their deposits (Farid & Salahuddin, 2006-2010). Basel 1 and II a capital accord dwells much on maintaining capital adequacy of commercial banks by encouraging sophisticated risk management activities. This is to ensure that the banks have a set level of risk tolerance and has adequate capital to cover all the risks. However, the accords ignore the importance of adequate liquidity that often leads to systemic banking crisis. Banks liquidity is affected by political and economic environment, interbank markets and bank image. Even if the banks managed to control credit, market and operational costs, factors that affect liquidity could render the bank insolvent. The Basel accords allowed for global banking by harmonizing capital requirements but allowed for interbank activities. This has created interrelatedness among banks and incase of illiquidity or insolvency, other banks are affected in the process. The risk spreads throughout the system and can lead to financial crisis (Melicher & Norton, 2011). The regulators need to carry out international harmonization of standardized quantitative liquidity reporting for stress testing. This enables supervisors to have more evidence-based views and comparisons of liquidity risk profiles of local and international banks. Quantitative liquidity data as well qualitative data is essential to enable information sharing and avoid speculations which run through the financial system leading to banking crisis (FSA, 2007). The regulators are moving towards new methods of asset-liability management to solve liquidity risks. The regulators also need to strengthen deposit administration and adopt more flexible approach to monitor liquidity (Greuning & Bratanovic, 2009). References Farid, J., Salahuddin, F (2006-2010) Internal Capital Adequacy Assessment Process (ICAAP): Overview and Core Concepts. Alchemy. Financial Services Authority (2007) Review of Liquidity Requirements for Banks and Building Societies. Financial Services Authority (2008) Strengthening Liquidity Standards. Fuller (2009) “Now, Re-regulation”. Financial World, the Journal of the Institute of Financial Services, May: 27-28. Gallati, R (2003) Risk Management and Capital Adequacy. USA: McGraw-Hill. Greuning, H., Bratanovic, S. (2009) Analyzing Business Risk: A Framework for Assessing Corporate Governance and Risk Management. Washington, D.C: World Bank. Melicher, R., Norton, E. (2011) Introduction to Finance: Markets, Investments, and Financial Management. 14ed. USA: Wiley. Read More