Question

What are the major methods utilized by the bank industry to manage its liquidity risk? Why does bank generally prefer to use liability management to manage its liquidity problem?

Answer 1

Banks face two major sub-groups of liquidity risks – funding liquidity risk and asset liquidity risk. Funding liquidity risk arises when banks are not able to meet its cash needs. Asset liquidity risks arises when banks are unable to effect a transaction at current market prices and this can be due to either relative position size or when the markets face a temporary drying up.

For managing its funding liquidity risks banks make use of diversification, through securing credit lines and other forms of back up funding and through limiting cash flow gaps. For managing its asset liquidity risks banks make use of controlling concentrations and relative market sizes of portfolios.

Banks generally prefer to use liability management because it ensures that banks are able to earn a desired level of net interest margin and that too without exposing the bank to any form of undue risks that can arise from interest rate volatility. It also helps banks to plan and structure their balance sheet so as to have a proper mix of assets and liabilities. This in turn will optimize the bank’s risk/return profile in future.