Liquidity &amp Profit MGT by P.rai87@gmail

Liquidity and profitability
management
Praveen rai
Liquidity
• A very basic definition of liquidity is
'the cash or money in a system'.
• Liquidity for a bank means the ability
to meet its financial obligations as
they come due.
Supply of liquidity
• Incoming customer
deposits
• Revenues from the sale

of non deposit services
• Customer loan
repayments
• Sales of bank assets
• Borrowings from the

money market
Demand for Liquidity
• Customer deposit withdrawals
• Credit requests from quality loan customers
• Operating expenses and taxes
• Payment of stockholder dividends

liquidity situation can impact
on
• Inflation
• stock markets
• rates of interest
• purchasing power

Tools to control liquidity
• 1 CRR
• 2 SLR
• 3 REPO RATE
• 4 REVERSE REPO RATE
CRR:-
• Cash reserve Ratio (CRR) is the amount of
funds that the banks have to keep with
RBI.
• it also kwon as cash asset ratio or liquidity
ratio
• it varies between 3-15%
• presentably it is 6%
SLR:-
• Statutory Liquidity Ratio is the amount
of liquid assets, such as cash, precious
metals or other short-term securities,
that a financial institution must
maintain in its reserves.
• it varies between 25-40%
• Presently it is 25%
• REPO RATE:-
BANKS BORROW@6% RBI

• REVERSE REPO:-
BANKS BORROW@5% RBI

Asset liability
management
• ALM can be termed as a risk
mgmt.
• It is Known as surplus
management
• It manages interest risk and
liquidity risk faced by banks.
• Banks manage the risks of
asset liability mismatch by
matching the assets and
liabilities according to maturity
pattern or the matching the
According to The Society of
Actuaries Task Force On ALM
Principles, Canada
“Asset- liability management is the

ongoing process of formulating,
implementing, monitoring and revising
strategies related to assets and
liabilities in an attempt to achieve
financial objectives for a given se of risk
tolerances and constraints.”
ALM is the art and science of analyzing,
interpreting and managing the composition of a
financial institution’s balance sheet.
Liabilities Assets
Capital Cash and balances at RBI
Reserves and surplus Balance with banks and

money at call and short
notice
Deposits Investments
Borrowings Advances
Other liabilities and Fixed assets

provisions
Contingent liabilities
Need of asset- liability
management
ALM focuses on up to four challenges:
•Understanding the risks that a bank is exposed to
due to the composition of its assets and liabilities.
•Forecast the future composition of the bank’s
balance sheet and its risk exposure.
•Determine and attribute interest-related profits to
individual assets or liabilities, business units or
activities through fund transfer pricing.
•Forecast capital requirements and manage the
balance sheet in a way to maximize shareholder
value.
Pre conditions for success
of ALM in banks
1. Awareness for ALM in the bank staff at all
levels- supportive mgmt. and dedicated terms
2. Methods of reporting data from branches other
departments.
3. Computerization- full computerization,
networking.
4. Insight into the banking operations, economic
forecasting, computerization, investment,
credit
5. Linking up ALM to future risk mgmt. strategies
Procedure of asset liability
mgmt.
• Step 1: Assessment of the assets/liability mix
• Step2: Identify the liquidity needs and assessing
the banks ability to meet liquidity needs.
• Step 3: The banks future development and
expansion plans, with focus on funding and
liquidity mgmt. aspects has to be looked into.
• Step 4:examining the bank’s
internal audit report in regards to
quality and effectiveness in terms
of liquidity mgmt.
• Step 5: Reviewing the bank’s plan

of satisfying unanticipated
liquidity needs
Techniques For Assessing
Asset-liability Risk
1. Interest risk management
2. Liquidity risk management
Interest risk management
1.Gap analysis
2.Duration model
3.Rate-shift scenarios
4.Simulation methods
Gap Analysis
• It is a tool used to analyze the match
between rate sensitive assets(RSA) and
rate sensitive liabilities(RSL).
• If RSA and RSL are evenly matched
The effect of interest rate changes will
be minimized while profitability is
maximized
Cond…
.
• Gap is the difference between RSA

and RSL for each time bucket.
• Positive gap (RSA > RSL)
Increasing interest rates would be
beneficial
for a bank
• Negative gap (RSA < RSL)
Falling interest rats would be
beneficial for a
Duration Model
• It takes into account the time of arrival of cash
flows and the maturity of assets and liabilities.
• It is the weighted average time to maturity of all
the preset values of cash flows.
• It refers to the average life of the asset or the
liability.
• The larger the value of the duration, the more
sensitive is the price of that asset or liability to
changes in interest rates.
• If duration gap is Zero, the bank will be
immunized from interest rate risk.
Rate-Shift Scenarios
• It is used to show the changes in earnings and value
expected under different rate scenarios.
• Rate shift scenarios attempt to capture the non-linear
behavior of customer.
• A common scenario test is to shift all rates up by 1%.
• After shifting the rates, the cash flows are changed
• Calculation of the NPV for this new set of cash flows
Simulation methods
• The purpose of using simulation methods
is to test the non-linear effect with many
complex rate scenarios
• It is very similar to Monte Carlo evaluation
• Simulation extends out over several years
rather than just one day
• It includes pricing models for financial
instruments as well as models for
consumer behavior.
Process for simulation
methods
Repeat for
next year
Repeat
for next
scenario
Liquidity risk management
Liquidity risk management is of
paramount importance because a liquidity
shortfall at a single institution can cause
system-wide problem.
Financial market development in the past
decade have increased the complexity of
liquidity risk and its management
Methods used in liquidity risk
management
• Liquidity tracking
• Time buckets
• CRR/SLR requirements
• Statement of structural liquidity
• Short term dynamic liquidity
Liquidity tracking
• For managing liquidity risk it is essential
to track liquidity which ensures the
company’s ability to meet its liabilities in
any adverse situation. For measuring and
managing net funding requirement , the
use of a maturity ladder and cumulative
surplus or deficit of funds at selected
maturity dates is adopted as a standard
tool.
Time buckets
• It is the method for measuring mismatches on
cash inflow and outflow as it provides early
warning signals of future liquidity problem
The time bucket will be distributed as under-
• 1 day to 30/31 day
• Over One to two month
• Over Two to three month
• Over Three to six month
• Over Six month to one year
Within each time bucket there could be mismatches
depending on cash inflows and outflows. While the
mismatches upto one year would be relevant since they
provide early warning signals
CRR/SLR requirements
• For every financial institute it is required
to maintain CRR / SLR on its customer
deposits and on all its liabilities
(SLR=5%).
• The financial institution holding deposits
are given freedom to place the
mandatory security in any time bucket as
suitable for them.these SLRs shall be kept
with the bank and financial institution for
different maturities.
Statement of structural
liquidity
• Statement of structural liquidity is
prepared by placing all cash
inflows and outflows in the
maturity ladder according to the
expected time of cash flows.
• A mature liabilities will be a cash
outflow and an maturing assets
will be a cash inflow.
Short term dynamic
liquidity
• Short term dynamic liquidity
is a method which enables
company to monitors its short
term liquidity over a time
horizon from one day to six
month.
Earning assets of bank
1.Cash balance with reserve bank

2.Balance with other banks
3.Money at call and short notice
4.Investment
5. Advances
Non performing assets
A non performing asset basically means an
asset which has ceased to generate
income for the bank . The banks have been
advised by their RBI that they should identify
non-performing assets and ensure that no
credit for interest is taken in respect of
the non-performing assets.
RBI asked on 30 th March 1994 to all five
term lending institution ( IBI, IFCI , ICICI , IRBI,
EXIM BANK ) identify the non performing asset
and see that no credit for interest is taken in
respect of such assets.
• Non- performing assets for banks
1.Cash in hand
balance with RBI:
a. in current account
b. in other account
2. Balance with banks and money at call
and short notice
balance with banks:
a. in current account
b. in other deposit account
3. Investment
a. govt. securities
b. other approved securities
c. shares, debentures/bonds
d. subsidiaries and / or joint ventures
4. Advances ( including bills)
a. bills purchased
b. cash credit
c. overdraft
d. term loans
5. Fixed assets
a. premises
b. furniture, fixture, computers
6. Other assets
a. prepaid taxes
b. interest on investment not colllected
etc.
Liquidity and Profitability
The basic problem for a bank manager is to have
a satisfactory trade off between liquidity and
profitability – the two principals but
conflicting goals of the banks. Because
The banker must maintain adequate amount of
liquidity in his assets so that he may be able to
meet the claims upon it on demand by the
customer, so banks need cash in hand. But cash
is a sterile asset which earns no income at
all.
if a banker holds a large portion his funds in cash
without earning any income on it the business
will result in losses.
Conclusion
Total cost
Minimum cost
Cost of liquidity
cost
Equilibrium or balanced situatio
Cost of illiquidity
Optimum level
Cost of liquidity = reduction of profitabilit
Level of current asset

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Liquidity and profitability

• Revenues from the sale

• Sales of bank assets

• Borrowings from the

• Credit requests from quality loan customers

• Operating expenses and taxes

• Payment of stockholder dividends

BANKS BORROW@6% RBI

BANKS BORROW@5% RBI

“Asset- liability management is the

Reserves and surplus Balance with banks and

Other liabilities and Fixed assets

• Step 5: Reviewing the bank’s plan

• Gap is the difference between RSA

1.Cash balance with reserve bank

Equilibrium or balanced situatio

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