Question

discuss about liquidity,funding,refinancing and reinvestment risks in banking management

Answer 1

Liquidity Risk:- It is define as a bank inability to raise sufficient flow of fund at the time of meeting obligation towards its lenders/depositiors. Bank, as a financial institution, do raise raise fund from various intistutions or from retail public (appear in liabiity side of bank balance sheet) and park those fund in the form of loan and advances (appear as an asset in bank balance sheet) to deficit sector mainly SME, household,corporates. The mismatch in maturity of liability and the asset creates the liquidity risk because the tenor of bank exposure in both asset and liability side normally are different. Suppose if bank has accepted a deposit of USD 1000 from retail public for 1 year and utilize the full amount in granting credit facility to corporate for 2 years then at the time of maturity of deposit, bank must have sufficient liquidity to reapy the deposit amount to retail public otherwise bank has to end up in raising the fund from other sources at higher cost due to which interest spread may decline. This mismatch in maturity of deposit and loans/advances creates liquidity risk. Other probable reason which may arise liquidty risk is the crystallization of off balance sheet exposure or a contigent liabilities on behalf of its client. In this situation, bank has to make payment upfront as and when claim is raised by beneficiary. Although bank has an option to recover the claimed amount from the applicant but it usually takes time. Making the payment immediately to beneficiary means raise the money from the market or utilizing the proceeds of loan repayment by borrower. The later option is not feasible due to mismatch in maturity so therefore bank usualy left with first option which sometimes proves costly to bank. The liquidity risk can me managed by reducing the gap between the maturity of loans/advances and the deposit. This task is undertaken by ALCO committe of every bank.

Funding risk: In Liquidity risk, we define that banks inablity to meet it commitment/obligation when due is called liquidity risk. Now second thought comes in mind is that how do bank honour its commitment. As bank main principle is to raise the fund from liquidity surplus sector and park the fund to liquidity deficit sector. Therefore bank , in order to honour its commitment, have to raised fund from other sources and there may be the possibility that bank has to raised that fund at high rate. This is called funding liquidity risk which arise in increase of cost of deposit. This has a negative impact on the net interest margin of banks.

Reinvestment Risk:- As banks utlilize the amount of deposit, raised from public, in providing the credit facility to borrowers. The borrowers has to honour its commitment at regular interval by repaying the loan to banks. However sometimes due to change in macro scenario, the liquidity position of the country needs to be enhanced. This can change the interest rate in country. Due to surplus liquidity in system, banks has to reduce the interest rate. Therefore bank could not get the same return by reinvesting the incremental cash inflow arise due to repayment of laon by borrowers due to the change in the interest rate.

Refiancing Risk:- The risk arise due to bank inability in refiance the existing mature deposit of its customers at the existing rate. This risk again arise due to difference in the maturity of deposit and loans. Suppose if bank has accepted a deposit of USD 1000 from retail public for 1 year and utilize the full amount in granting credit facility to corporate for 10 years then at the time of maturity of deposit, bank must have sufficient liquidity to reapy the deposit amount to retail public otherwise bank has to raised the existing deposit interest rate so as to attract depositors to reinvest maturity amount again with bank.