ALM/GAP Management:

Commercial Banking Operation

Md. Saif Noman Khan

Faculty
IBA. University of Dhaka
CB-Core Business

CB is a business where money is borrowed in the form of

Deposits (Liabilities) and then used to make loans and
purchase securities (Assets)
Hence CB business means fundamentally Asset Liability
management.
In other words Managing the balance Sheet to match the
Asset and Liabilities in terms of Size, Maturity, IR.
In CB Money and Loan/Credit are the basic products. The
price is the IR that must cover the deposit rate as well as
the cost of doing business.
Funds

The prime assets and liabilities of a financial institution is FUNDS

Fund Managers have the responsibility to manage the pricing

and funding risk

Based on current and Adequate availability

forecast market of fund at all times

YIELD CURVE (Liquidity)

(Interest Rate Mismatch)

Why Funds Management

To manage financial risks arising from movements in

market factors

Main Risks
Credit Risk
Liquidity Risk
Reinvestment Risk
Refinance risk
Interest Rate risk
FX Risk
Country/Sovereign Risk
Technology Risk
Reputation Risk or Franchise Risk
Organizational Structure
Some Recap

CIB: Birth & Impact on the market

Micro Credit Securitization
Relationship between Risks & Innovation in the Financial
Market (Swaps, Options, Forward, Derivatives etc.)
Reserve Requirement & Lending Rate (MUST exceed deposit
rate even if TXN cost was zero)
Small depositors & Financial System Efficiency
They are the largest source of funds & Evolution of Banks
made it possible
Reverse Deregulation
BDG market & innovative products: Not yet feasible
CB Broad Roles

CBs play critical role in any economy. Some of their core

activities include:

Provide liquidity to the economy in the form of offering Savings

A/Cs, CDs
Credit giving
Custodians of the communitys money
The manager of transfer of money
Fiduciary services Safe keeping, Trustee etc.
CB services
Personal / Consumer Banking Corporate Banking
Deposit Services Savings Deposit Services Savings
Loan services Consumer loans Loan services OD (Overnight),
(Education, car, house, marriage WC (1-6 month)
so many types)
Trust services syndication,
Trust services Locker services securitization, escrow account
Other services ATM, Travellers International trade Import,
Chq, Advisory Export, LC
Capital market services BO FX dealing - Treasury
account etc.
Guarantee (Bank VS Corporate)
FX services (Buy-Sell).
Advisory
Utility bill payment
Cash Management Collection,
Payment, MM operation (Purchase
T-Bills on behalf of customers)
CB - Strategies for Increasing Return
What do they do?
By considering the environment increase the interest for many new
loans the bank may make---
Re-Package some of the existing loans in a way so that the overall return
will increase
Reduce loan/transaction processing costs. Quickly say yes/no have a
standard format
Use information Examine ways to change the mix (A L) which will
contribute to the overall earning of the bank
Hedging this is a procedure whereby the Fund manager controls or
mitigates the risk by engaging in offsetting Txns.
General Hedging ST assets are financed by ST liabilities
Specific Hedging for FX txns, make a sell for every buy.
Floating rate emerged as a hedging tool
ALM - GAP Mgt
Managing interest sensitivity Gap

This model is applicable ONLY in times of RISING IR

To finance most of the Interest sensitive Loans by Interest
insensitive deposits.
This model emphasizes the dynamic changes that occur in IR,
that generate certain situations which you can take advantage of
by acting on your expectations about IR over the Credit Cycle
as like a business cycle.
Go for indexing the long term Loans/Assets with the Prime
Rate and at the same time lengthen the long term CD maturities
at the earliest stage of the IR increase.
As a result, this behavior of IR will benefit you in respect of IR
margin
ALM-GAP Mgt Contd.
Interest sensitive assets financed by interest insensitive liabilities

The Gap is the gap created by the difference between the size of
the Interest sensitive assets interest insensitive liabilities
Asset Liability

Interest sensitive Interest sensitive

Assets (Floating Deposits
Rate Loans). ST (Floating Rate ST
Deposits).

Interest GA Interest
Sensitive/
P Insensitive/Fixed
Floating Rate LT
Rate LT Deposits
Loans

Mortgages (Fixed Time Deposits

Rate) (FDR)

ALM Strategy in a time of rising IR

Questions?

11
Existing Procedure and Guidelines for approval of Foreign Private Loan.

With a view to promote foreign investment in the private sector through easier long term
financing of industrial project at lower cost of fund and to lessen the pressure on foreign
currency reserve, the Government of Bangladesh has been allowing foreign borrowing duly
approved by the Scrutiny Committee.

The Existing guidelines for borrowing from abroad are set out below:

1. Category and eligibility

Industrial enterprises in private sector incorporated under the Companies Act 1994 and
registered with BOI are eligible;
(ii) Foreign Borrowings;
Foreign borrowings refer to commercial loan including financial loans, bank loans,
buyer's credit, supplier's credit from institutions or individuals and debt issues in the
capital market abroad etc;
(iii) Recognized Lenders;
Borrowers can raise the foreign borrowings from internationally recognized sources such
as (i) international banks, international capital markets, multilateral financial institutions
(such as IFC, WB, ADB, CDC, DEG, FMO, OPIC, OPEC Fund etc). (ii) export credit
agencies and (iii) suppliers of equipment and (iv) apart from these approval of borrowing
from foreign equity holders and their connected interests will be accorded sparingly, only
by way of short term bridging arrangements.
(iv) All-in-cost ceilings;
All-in-cost includes rate of interest and other annualized fees and expenses such as
commitment fee, syndication fee, front-end fee, project appraisal fee, legal fee etc.
payable in foreign currency except pre-payment fee and fees payable in Bangladesh Taka.
The interest rate and other charges related to the foreign borrowing should be reasonable
compared to the prevailing lending rates at the international markets in the concerned
currencies for the relevant tenure. Normally, the interest rate should be based on
prevailing govt treasury bond rate in that currency for that tenure plus a reasonably
moderate country risk premium; excessive high risk premium margins will invite
 additional rigour in the scrutiny of the approval process. The foreign borrowings must be
at competitive rates and that the all in cost level should be in line with prevailing
borrowing costs in the international market.
(v) End use;
(a) Foreign borrowing will be allowed only for investment (such as import of capital
goods for new projects, modernization/expansion of existing production units) in
industrial sector including small and medium enterprises (SME) as well as
infrastructure and priority sector as defined in Industrial Policy announced from time
to time;
(b) Utilization of foreign loan proceeds is not permitted exclusively for working capital
purpose and investment in capital market by corporate;
(vi) Guarantees;
Guarantee/stand by letter of credit or letter of comfort by banks, financial institutions
relating to foreign borrowing is usually not permitted. However providing of such
guarantee/stand by letter of credit or letter of comfort etc is subject to existing
prudential regulations of Bangladesh Bank;
(vii) Prepayment;
Prepayment of approved foreign borrowings shall be subject to concurrence of
Bangladesh Bank before being submitted for approval of the BOI Scrutiny
Committee.
(viii) Refinance of existing approved foreign borrowings;
Refinancing of outstanding foreign loan by borrowing fresh loans at lower cost is
permitted with prior approval of the Scrutiny Committee. In such case, the maturity
of the fresh loan should not be less than the outstanding maturity of original loan;
(ix) Payment of arrears (if any):
Payment of arrears (if any) for interest and principal should be made in installments
as approved by the Scrutiny Committee.
(x) Quality/Commercial viability of the project;
To determine the quality/commercial viability of the project feasibility report
alongwith the following financial analysis are required;
a) Internal Rate of Return (IRR) of the project
 b) Pay back period
c) Break-even point at what capacity and what period of year
d) Sensitivity analysis in terms of IRR.
e) Debt Service Coverage Ratio (DSCR)
(xi) Indebtedness and creditworthiness of the borrowing company;
To determine the existing indebtedness structure and creditworthiness of the borrowing
company as well as its sponsors;
(a) CIB report : CIB report will be required for processing of all proposals. BOI will collect
the CIB report from Bangladesh Bank.
(b) Bank certificate: Existing indebtedness structure and creditworthiness of the sponsors
concerned duly certified by their bankers will be required for approval process of
foreign borrowings. The nominated bank will submit the relevant inquiry forms and
undertaking from the Sponsor Directors of the borrowing company to BOI.
(xii) Repayment period: Approval requests should normally be for medium and longer term
borrowing and that short term borrowing approvals will be considered only sparingly by
way of bridging arrangements.
2. Criteria for foreign borrowing
i. Debt equity ratio;
Debt-equity ratio based on proposed borrowing should be sector wise at a tolerable level.
The debt-equity ratio of the borrowing enterprise should reflect sufficient equity stake of
the entrepreneurs, with moderate rather than high leveraging and also that while
relatively higher debt levels may be warranted for long gestation infrastructure projects,
total debt including the proposed borrowing should not breach 70:30 debt equity ratio
even for these projects;
ii. Liabilities to the Government;
There should be absolutely no liability either in Taka or in foreign exchange for the
Government of Bangladesh and any of its entities or Bangladesh Bank.
iii. Status of implementation & utilization report of approved foreign borrowing;
The borrowing company should submit the status of implementation and utilization
report of the approved loan as per prescribed format to the BOI on semi annual basis.
iv) Quality, price and economic life of capital machinery and equipments to be procured;
 The capital machinery and equipments to be procured with the proposed borrowing
should eigther be brand new; or in case there are reconditioned should be of such
sufficient useful life as required by the Governments Import Policy Order.
v) Validity of the approval;
Approval of the foreign borrowing given by the Scrutiny Committee will be valid upto
6(six) months from the date of approval letter issued by BOI.
vi) Common Terms;
a) The borrowing company shall have to abide by the rules and regulation of Bangladesh
Bank in respect of utilization and repayment of the said loan and interest thereon.
b) The borrowing company shall have repayment of the said loan alongwith interest out of
their own sources.
c) The borrowing company shall have to bring in the proceeds of the loan through any
Authorized Dealer(AD) bank only operating in Bangladesh as nominated in application
for approval of foreign borrowing.
d) The borrowing company shall have to submit the certified/attested copy of the final
agreement made between the borrower and non-resident lender of the approved loan to
the Director (R&I-I), Board of Investment, Jiban Bima Tower, 10, Dilkusha CIA, Dhaka,
General Manager, Statistics Department, Bangladesh Bank, Head Office, Dhaka and
other concerned agencies.

3. Procedure for application

Applications as per proforma at Annexure-A for approval of proposals for borrowing
from abroad should be submitted to the Board of Investment (BOI) with the following
analysis and supporting documents;
i) Application form (Annexure-A) duly filled in;
ii) MOU signed by both parties. In case of draft agreement the borrowing company shall
have to submit a consent letter from the non-resident lender summarizing the major
terms and conditions (such as principal amount, rate of interest, repayment period
other fees and expenses if any etc);
iii) Copy of BOI project registration (full set);
iv) Boards resolution relating to proposed borrowing;
v) Repayment period alongwith repayment schedule in details;
 vi) Gracelgestation period if any for repayment;
vii) Calculation of all-in-cost with schedule as defined in the application form (Annexure-
A);
viii) Feasibility report of the project;
ix) Financial analysis
a) Internal Rate of Return (IRR);
b) Year of achieving break-even point with break-even analysis;
c) Pay back period;
d) Sensitivity analysis in terms of IRR;
e) Debt Service Coverage Ratio (DSCR);
x) Track record of past foreign borrowing( if any in the attached format-Annexure-B)
xi) Track record of past FDI;
xii) Credential of the sponsors;
xiii) Certified copy of Memorandum & Articles of Association of the company alongwith
schedule-X and form XII;
xiv) Certificate of incorporation with Registrar of Joint Stock Companies & Firms;
xv) As to collect CIB report from Bangladesh Bank, the relevant inquiry forms and
undertaking from the Sponsors Director;
xvi) Bank certificate as to indebtedness and creditworthiness of the borrowing company
and its Sponsors from the nominated bank/designated bank;
xvii) Undertakings/consent from the L/C opening bank for opening 4C in favor of the
project (in case of suppliers credit only);

Fully documented proposals will be placed before the Scrutiny Committee headed by Governor,
Bangladesh Bank for final approval.
Trade Finance & Services

0
 Course Outline

Introduction

Product - basics

 Imports

 Exports

 Guarantees

1
 TRADE

Concept of self-sufficiency

Extinction of the Barter System due to usage of Money

Developments in transport and hence expansion of the
Economy

THE NEED FOR INTERNATIONAL TRADE-

Competencies on account of:
Technological Advancement
Geography
Manpower
Natural resources

2
 TRADE PROBLEMS -
SELLER

We want to be certain that the buyer

will pay on time once the goods have
been shipped. How can we minimize
the risk of non-payment?

How can the banks help us in

arranging for the transaction,
especially the documentation?

3
 TRADE PROBLEMS -
BUYER

We do not know the seller...can we be sure

he will deliver on time?

Before we pay, how can we check that the

goods are exactly those we ordered?

We would prefer to delay paying for the

goods till we have them. Can our bank
provide credit for the intervening period?

4
 Requirements - Buyer and
Seller

Contract fulfillment

Convenience

Credit / prompt payment

Expert assistance / advice

5
 What happens when .?

Buyer - Seller dont trust each other

Third Party credibility needed

Cross border commerce

Financing structures needed

Credit period needed

Advance Payment extended

Various risks need to be hedged (country,
transfer etc)

6
 INCOTERMS
contd...

Cost of Merchandise

SELLERS BUYERS
FACTORY PREMISES

Transportation
to Dock

CFR CIF
DOCK OF FOB DOCK OF
TRANSPORTATION IMPORTATION
Loading onto Ocean Freight Marine
Vessel Insurance

7
 Payment Methods

Advance Payment

Open Account

Documentary Collection

Letter of Credit

8
 Advance Payment

Mechanism under which payment is made in

advance by the importer, after which the
exporter makes the shipment.

9
 CASH IN ADVANCE

ADVANTAGE TO BUYER
ADVANTAGE TO SELLER

 None  Use of funds
 No binding

RISK TO BUYER
RISK TO SELLER

 Funds committed  None
 No control over
goods
 Seller may not ship

10
 Open Account

A mode of payment whereby the shipping

documents are sent by the exporter directly
to the importer, without coursing the
documents through the banks, upon the
buyers promise to pay at some future date
after shipment.

11
 OPEN ACCOUNT
contd...

ADVANTAGE TO BUYER
ADVANTAGE TO SELLER

 Pay when you like  None
 Control over goods

RISK TO BUYER
RISK TO SELLER

 None  No control over
goods or payment
 Buyer may refuse to
pay

12
 Documentary Collections

Seller sends documents thru his banker to

buyers bank

Buyers bank asks buyer to either
 pay and get the documents (D/P)

 accept to pay on a future date and get documents

(D/A)

 refuse to pay (in which case buyers bank will notify

seller)

Risk Remains the same as in open account but the bank gets
the documents without any liability on its part to pay

13
 COLLECTIONS

Definition-

Collection means the handling of

documents(financial or commercial) by banks, in
accordance with instructions received, in order to:
obtain payment and/or acceptance
deliver documents against payment and/or
against acceptance
deliver documents on other terms and
conditions

14
 COLLECTIONS
contd...

Clean Collection-
Collection of financial documents not
accompanied by commercial documents

Documentary Collection-
Collection of:
 Financial documents accompanied by commercial
documents
 Commercial documents not accompanied by financial
documents

15
 Collections -
Document Flow

Seller
Remitting
Bank
Title Docs

Buyer
Collecting
Presenting
Title Docs Bank

Banks act only as intermediaries keeping documents from Buyer

until payment or acceptance of draft 16
 Documents against
Payment

A mode of payment whereby the exporter

ships the goods to the importer and sends
the shipping documents through his bank
for collection, together with a draft drawn at
sight on the importer. Payment is made
either via telegraphic transfer or demand
draft.

17
 Documents against
Acceptance

A mode of payment whereby the exporter

ships the goods to the importer and sends
the shipping documents through his bank
for collection, together with a draft drawn at
on the importer at a fixed determinable
future date. Payment is made either via
telegraphic transfer or demand draft.

18
 Collections -
Funds Flow

Seller
Remitting
Bank

Buyer
Collecting
Presenting
Bank

Seller has no assurance from either the Remitting Bank or the Collection/
Presenting Bank that payment will be made

19
 COLLECTIONS
contd...
PARTIES TO A COLLECTION:

The Principal- party entrusting the handling of a collection
to a bank (Exporter)

The Remitting Bank- bank to which the principal has
entrusted the handling of a collection

The Collecting Bank- any bank, other than the remitting
bank, involved in processing the collection

The Presenting Bank- the collecting bank making
presentation to the drawee

The Drawee- is the one to whom presentation is to be
made in accordance with the collection instruction
(Importer)
20
 Documentary Collections -
Seller

Risks
 Delay in Payment
 Buyers Refusal of Shipment
 Buyers Bankruptcy
 Adverse Effect of Local Customs Regulations
 Exchange Control Delays

Considerations
 Commercial Risk
 Country Risk
 Control of Merchandise

21
 The Letter of Credit...

is a conditional bank undertaking of

payment

is an arrangement by banks to facilitate
and settle international trade

provides a form of security to the parties
involved

ensures payment provided the terms and
conditions of the credit have been
fulfilled

payment is based on DOCUMENTS ONLY
AND NOT ON MERCHANDISE.

22
 Letter of Credit -
Advantages

Seller
 Creditworthiness of bank replaces that of buyer
 Shift the sovereign risk of the buyers country
to a bank
 Financing options

Buyer
 Seller will not be paid unless his documents
conform to terms and conditions of the LC
 Flexible payment terms

23
 Letter of Credit -
Risks (1)

Seller
 Sellers documents must conform exactly to
the terms and conditions of the letter of credit
to ensure payment.

Buyer
 Letters of Credit deal only in documents, not
in goods. The goods may not be as
represented in the documentation

24
 Letter of Credit -
Risks (2)

Credit Risk
 This is the principle risk in the product, and arises
on the grounds that the importer does not make
payment on the due date. This risk is mitigated as:
LC facilities are a part of the aggregate non
fund based facilities and are extended only
after a detailed Credit Approval process
all documents (unless the Credit Team
approves the exception) are consigned to the
order of the bank, and a full set of documents
are called for under the letter of credit.

25
 Letter of Credit -
Risks (3)

Product and Processing Risks

 Buyer - Seller Dispute
As the bank deals only in documents, it has to make
the payment as per the UCP provided the documents
are clean. The recourse to the customer is boxed in
through the customer indemnity.
 Errors of the Negotiating Bank
This arises on account of non-detection of
discrepancies by the negotiating bank. In such
cases, there is a possibility that the negotiating bank
may have debited the Nostro and paid out the
beneficiary.

26
 The Last Word...

The integrity of the buyer and seller remain

paramount in any exchange of goods -
regardless of payment vehicle.

27
 Parties to an LC

Applicant

Beneficiary

Issuing (opening) Bank

Advising Bank

Paying Bank

Negotiating Bank

Confirming Bank

28
 Applicant

Also the importer or buyer

Arranges for the issuance or establishment
of the Letter of Credit

29
 Beneficiary

Seller

Party or parties in whose favour the LC is
issued.

The recipient of the funds

30
 Opening or Issuing bank

Applicant's bank that opens, issues or

establishes the Credit

Must honour documents if in order

31
 Advising Bank

Bank that authenticates and advices the

establishment of the LC to the Beneficiary

Obligations - To authenticate and transmit

32
 Paying Bank

The paying bank is the bank nominated in the

credit by the issuing bank that will be responsible
to effect the payment on behalf of the issuing
bank.

The paying bank always pays without recourse to
the beneficiary

33
 Negotiating Bank (1)

Usually an unnamed bank, that under the

terms and conditions of a LC is permitted, at
its discretion to advance funds to the
beneficiary against conforming documents

34
 Negotiating Bank (4)

Alternatives available if the documents

presented by the beneficiary do not meet
the credit requirements:
 Return to beneficiary to have them corrected for
resubmission within LC validity and within
presentation period
 Send documents for approval
 Cable the issuing bank for authority to
pay/negotiate/accept
 Return the documents to the beneficiary

35
 Confirming bank

Bank that adds its irrevocable commitment

to the issuing Banks LC lending its
creditworthiness in addition to that of the
Issuing Bank. Confirming Bank must be
authorised to perform this action by the
Issuing Bank

Obligations - Not obliged to confirm but if it
does, has no recourse to the beneficiary.

36
 Key Terms and
Conditions in an LC

Beneficiary

Amount

Expiration

Last date of shipping

Last date for presentation

37
 LC Opening :
Basic Rules

instructions to the opening bank should be

CLEAR/CORRECT/PRECISE.

All terms and conditions should be
DOCUMENTARY in nature

the terms and conditions should agree with
those of the contract

38
 LC Opening :
Flow

Seller/ (1) Buyer/

(Beneficiary) Sales (Applicant)
Contract
(4) (2)
LC Advice LC Application

Advising Bank Issuing Bank/

(3) Opening Bank
LC Issuance

39
 LC RETIREMENT :
FLOW

SELLER/ (1) BUYER/

(BENEFICIARY) Sales (APPLICANT)
Contract
(4) (5) (7) (2)
LC Advice Negotiation Billing / LC Application
Docs

(6) Docs
NEGOTIATING BANK
ISSUING BANK
(3)
LC Issuance

40
 COMMERCIAL DOCUMENTS
contd..

Contains:
A. Date
B. Name and address of the seller and the buyer
C. Order number / contract number / proforma invoice
or LC details
D. Description, quantity and quality of the goods.
E. Terms of sale
F. Port of shipment and port of destination
G. Value of goods, and any adjustments like advance/
discount and the total payment to be made
H. Shipping marks or number on packages identical to those given
in other documents

41
 FINANCIAL DOCUMENTS
contd...

 Made for a fixed amount

 Amount must be the same as the commercial
invoice amount
 Should be drawn by the beneficiaries on parties
mentioned in the LC
 Should not exceed the LC amount
 Should not be drawn payable to parties other
than the beneficiary (or his banker)

42
 Common discrepancies
during retirement

no evidence of
documents
goods shipped on inconsistent
board
LC expired

shipments to ports
LC overdrawn
other than those in
Documents not
LC presented in time

BL not clean
late shipment

Insurance does not
documents not
cover risks specified endorsed correctly
in LC

benes name /

under-insured address differs

description of goods
in invoice differs
43
 Documents in an LC

Commercial Invoice

Bill of Exchange

Insurance

Bill of Lading / Airway Bill

Other - Certificate of origin; Packing List;
Inspection Certificate

44
Liquidity Risk at Banks: Trends and Lessons Learned
from the Recent Turmoil
Jim Armstrong (Bank of Canada) and Gregory Caldwell (Office of the Superintendent of Financial Institutions)

The market turmoil that began in late 2007 underscored the Liquidity-risk management seeks to ensure a banks ability to
importance of liquidity to the functioning of financial markets continue to perform this fundamental role. While some out-
and the banking sector. Prior to the turmoil, asset markets flows are known with certainty, risk arises from the need to
were buoyant, and low-cost funding was readily available. The meet uncertain cash flow obligations, which depend on exter-
reversal in market conditions illustrated how quickly liquidity nal events and on the behaviour of other agents.
can evaporate, and that illiquidity can last for an extended
period (Basel Committee 2008b). Banking systems around The liquidity situation of an individual bank is ultimately a
the world came under severe stress, necessitating central function of confidence: the confidence of counterparties and
bank actions to support both the functioning of money mar- depositors in the institution and its perceived solvency or cap-
kets and, in some cases, individual institutions. ital adequacy. A liquidity shortfall at a single institution can
have system-wide repercussions, since a withdrawal of confi-
Bank supervisors regularly review the liquidity positions and dence in one institution can spread to others that are per-
liquidity-risk-management practices of banks and provide ceived to be exposed to it or to similar problems.1
banks with liquidity guidelines. The recent turmoil revealed
certain weaknesses in these practices that are now being The distinction is frequently made between funding liquidity
addressed by supervisors globally. risk and market liquidity risk (IIF 2007). Funding liquidity
risk is the risk that the firm will not be able to efficiently meet
Central banksas the ultimate source of liquidityare taking both expected and unexpected current and future cash flows
an enhanced interest in liquidity risk. The recent events have and collateral needs without impairing the daily operations or
highlighted the central bank as key stakeholder in this area. the financial condition of the firm. Market liquidity risk is the
Both the Financial Stability Forum (FSF 2008) report and the risk that a firm cannot easily offset or eliminate a position
September 2008 Basel Committee report on liquidity risk rec- without significantly affecting the market price of the security,
ommend that central banks take a more active role in the area because of inadequate market depth or market disruption. The
of liquidity riskincluding reviewing the liquidity contingency focus of this article is on funding liquidity risk.
plans of banks.
What is unique about liquidity risk?
BANKS AND LIQUIDITY RISK
Prominent economist Charles Goodhart has noted that,
It has been said that liquidity is easier to recognize than Liquidity and solvency are the heavenly twins of banking, fre-
define (Crockett 2008) and that it can be an elusive concept. quently indistinguishable. An illiquid bank can rapidly become
In its barest essentials, however, liquidity is about having insolvent, and an insolvent bank illiquid (Goodhart 2008).
access to cash when you need it. A specific definition of Even though strong capital positions reduce the likelihood of
liquidity pertaining to banks is that it represents the capacity liquidity pressure, apparently solvent banks can experience
of a bank to fund increases in assets and meet obligations as liquidity problems. Although problems with funding liquidity
they come due, without incurring unacceptable losses (Basel at banks can arise at any time, they will be most severe in an
Committee 2008a).
1. It is important to note that significant progress in risk-proofing systemically
important clearing and settlement systems in Canada, such as the LVTS,
The fundamental role of banks typically involves the transfor- CDSX, and CLS Bank, has virtually eliminated the risk that default by one insti-
mation of liquid deposit liabilities into illiquid assets such as tution would spread to others as a result of transactions conducted through
these systems.
loans; this makes banks inherently vulnerable to liquidity risk.

POLICY AND INFRASTRUCTURE DEVELOPMENTS

BANK OF CANADA FINANCIAL SYSTEM REVIEW DECEMBER 2008 47
environment of heightened market-liquidity risk, as witnessed events. The decision about which events a bank will defend
during the latest turmoil. The close link between these two itself against depends on strategic choices, such as the banks
risks has been noted, including the fact that the same events tolerance for risk and its business model.4
may trigger both (Matz and Neu 2007).
IMPACT OF RECENT FINANCIAL DEVELOPMENTS ON
Liquidity risk is sometimes thought of as a consequential risk LIQUIDITY RISK
or second-order risk because it normally would not come
about without a sharp rise in one or more of the other major Prior to the credit crisis, it was generally believed that liquidity
financial risks (Matz and Neu 2007). Unlike the other major riskarguably the most basic of banking riskswas well
financial risks, liquidity risk can arise on both sides of the bal- understood. However, it was perhaps not fully appreciated
ance sheet.2 It can be triggered by exogenous or endogenous that financial innovation and global market developments in
events. The trigger event might be, for example, a firm-specific recent years had altered certain facets of liquidity risk in
operational-risk problem or damage to the banks reputation important ways (Basel Committee 2008a). The consequences
(endogenous), or a market-wide liquidity problem (exoge- of some of these developments became strikingly apparent
nous). Trigger events tend to undermine confidence in an insti- during the recent turmoil.
tution very quickly. This, in turn, leads to a rapid erosion in its
liquidity position, for example, from a rapid loss of wholesale Reliance on capital markets
deposits.3 Liquidity risk can, in turn, interact with market risk
and credit risk in complex and unanticipated ways. First, the funding of major banks has shifted towards a greater
reliance on wholesale funding (wholesale deposits, repur-
Managing liquidity risk chase agreements, and other money market instruments)
from institutional and corporate investors (both financial and
Banks hold liquid assets as a buffer against liquidity pressures. non-financial)a typically more volatile source of funding
Liquid assets comprise those types of assets that are generally than traditional retail deposits. Chart 1 presents the long-term
expected to hold their value over time, that have low transac- trend in reliance on wholesale funding for the major Canadian
tions costs, and that can therefore be quickly transformed into banks as a group. Total wholesale funding as a share of total
cash, when needed, at low cost. These assets must be unen- funding is currently at levels that had been previously seen in
cumbered, that is, not pledged to other entities or tied to the 1980s, but the composition has shifted from bank to non-
specific financial transactions. bank deposits. The sharp rise in reliance on wholesale funding
that began in the 1990s reflected slow growth in retail depos-
To access cash in the very short run, banks have three basic its as individual investors shifted their assets into mutual
options: they can sell or redeem unencumbered liquid assets, funds. This trend suggests that banks may be assuming more
they can borrow (either from private sources or from the cen- funding risk. It should also be noted that about half of whole-
tral bank) on a secured or unsecured basis, or they can access sale funding is done in foreign currencies, which tends to pose
new cash generated from operations. To deal with a long-term more risk than funding in domestic currency. On the other hand,
liquidity need, banks endeavour to sell less-liquid assets and the fact that the share of this funding coming from other banks
access more permanent funding through the capital markets. is declining tends to dampen the potential for systemic risk.

What is a sufficient amount of bank liquidity? This is a difficult At times of severe market stress, sophisticated wholesale
question that depends on a variety of factors. Clearly, there is investors tend to exhibit heightened risk aversion. This was
an opportunity cost to holding liquid assets because they offer made very apparent by the severe funding problems experi-
a very low return, reflecting their low risk and the high demand enced in 2008 by major U.S. investment banks that lacked a
for collateral in the market. Indeed, there is an adage in the stable retail deposit base. At such times, investors can
banking worlda lack of liquidity can kill a bank quickly, demand higher compensation for risk and greater discounts to
whereas too much liquidity can kill a bank slowly. Normally, collateral assets with uncertain cash flows, require banks to
banks hold sufficient liquid assets to stand up to all potential roll over liabilities at considerably shorter maturities, or refuse
cash demands resulting from high-probability, low-severity to extend financing. In these cases, refinancing sources must
events, and to some, but not all, low-probability, high-severity be found quickly to replace the loss of funding.5

2. The broad categories of financial risk that banks are subject to include credit
and counterparty risk, market risk, operational and legal risk, and liquidity risk.
See Aaron, Armstrong, and Zelmer (2007) for an overview of these risks and
their management at the major Canadian banks. 4. These strategies are usually established by the Board of Directors and are exe-
cuted by management and various delegated committees.
3. The severe difficulties and eventual demise of the U.K. bank, Northern Rock, in
2007 (and some other cases globally), underlined how a precipitous loss of 5. Of course, investors must put their funds somewhere during such periods.
confidence in an institutions funding strategy can bring liquidity risk to the They may acquire risk-free assets such as treasury bills, being content to earn a
forefront. Thus, at times, liquidity risk can become a first-order risk. lower return until the crisis subsides.

48 POLICY AND INFRASTRUCTURE DEVELOPMENTS

BANK OF CANADA FINANCIAL SYSTEM REVIEW DECEMBER 2008
 Rising demand for collateral
Chart 1
Wholesale Funding as a Share of Total Funding: Major Banks A third recent trend has been expanded demand for high-
quality collateral. This trend is due partly to an increase in the
%
70
Total wholesale funding (includes deposits,
70
use of collateral for pledging purposes to mitigate risk (Aaron,
bankers acceptances, and repos)
Foreign currency funding Armstrong, and Zelmer 2007) and partly to the changing
Interbank funding
60 60
nature of transactions between financial firms, including the
increased use of repos and derivatives in the wholesale fund-
50 50
ing markets. Rising demands from real-time payment and set-
tlement systems have also notably increased intraday demand
40 40
for collateral.

30 30
Chart 2 shows that, for the major banks, pledged liquid assets
as a share of total liquid assets have risen considerably in
20 20
recent years.

10 10 Chart 2
1980 1985 1990 1995 2000 2005
Pledged Liquid Assets: Six Major Canadian Banks
Percentage of total liquid assets
Source: OSFI

32 32

30 30

28 28
Securitization
26 26

Many banks had come to rely increasingly on securitization as 24 24

a source of fee income and as a way to reduce capital and
liquidity requirements. However, during the recent turmoil, 22 22

liquidity pressures arose as some of these banks were forced 20 20

to postpone some planned securitizations and faced a buildup
of warehoused assets that had to be financed. Some forms of 18 18

securitization (i.e., ABCP conduits) gave rise to contingent 16 16

liquidity risk, i.e., the need to provide liquidity under backstop 2004 2005 2006 2007

arrangements, at a time when the sponsoring bank was

already under stress.

Canadian banks had tended to rely relatively less on securiti- While the use of collateral mitigates counterparty credit risk, it
zation as a funding source than, for example, their U.S. coun- can aggravate funding liquidity risk because counterparties
terparts. In addition, the government-sponsored Canada have to provide additional collateral at short notice if condi-
Mortgage Bond (CMB) Program for securitizing residential tions change. The more widely collateralization is used, the
mortgages has functioned very well through the turmoil. more significant this risk becomes, especially as market price
movements in hedged portfolios result in changes in the size
Some Canadian banks, however, provided support to some of of counterparty credit exposures. During the recent turmoil,
their own bank-sponsored ABCP that could not be success- shortages of high-quality collateral emerged, prompting
fully refinanced. Some experienced liquidity pressures from special operations by some central banks.7
difficulties with other off-balance-sheet entities such as third-
party ABCP, structured investment vehicles, and other struc- Cross-border flows and global liquidity management
tures that they occasionally chose to support for reputational
reasons.6 Another financial innovation that can complicate the manage-
ment of liquidity risk is the extent of cross-border flows. Large
global financial institutions are increasingly seeking to manage
6. On balance, these developments proved manageable for Canadian banks. This
was because the Canadian banks were in sound financial condition before the
crisis and were able to fund themselves successfully in a range of capital mar- 7. Having access to high-quality collateral did not always guarantee that troubled
kets. See the June 2008 FSR (pp. 21 and 23) for more detail on these develop- institutions could maintain access to wholesale funding, as evidenced by the
ments. case of Bear Stearns.

POLICY AND INFRASTRUCTURE DEVELOPMENTS

BANK OF CANADA FINANCIAL SYSTEM REVIEW DECEMBER 2008 49
their intraday and overnight liquidity demands (including col- The Committee recommends that banks incorporate liquidity
lateral) in a centralized manner across currencies and across costs, benefits, and risks in the pricing, performance mea-
borders. surement, and approval process for all significant business
activities (both on and off the balance sheet).
Such banks must, consequently, factor into their plans the
conditions in overseas markets, as well as the time it takes to Measuring off-balance-sheet exposures
complete the transfer of funds or collateral across jurisdic-
tions. A bank needs to take into account the risks of sudden Many banks had apparently underestimated the liquidity risk
changes in exchange rates and liquidity conditions in foreign they had assumed pertaining to related off-balance-sheet
markets, which can sharply widen liquidity mismatches and entities. The Basel Committee recommends that a bank
reduce the effectiveness of foreign exchange hedges (Basel should identify, measure, monitor, and control potential cash
Committee 2008b).8 flows relating to off-balance-sheet commitments and other
contingent liabilities. This should include an analysis of
The global experience has shown that liquidity may not be potential non-contractual exposures that arose because of
fully transferable across borders, particularly in times of mar- reputation concerns.
ket stress, and that pockets of liquidity can potentially be
trapped. For example, during the recent turmoil, the normal Intraday liquidity
ability of banks to swap currencies sometimes dried up during
times of stress. The management and supervision of cross- The document introduces a principle on the management of
border liquidity will continue to be a focus of current and intraday liquidity risk. A bank should actively manage its
future reviews of liquidity-risk management. intraday liquidity positions and risks to meet payment and set-
tlement obligations on a timely basis under both normal and
THE BASEL COMMITTEES NEW stressed conditions and thus contribute to the smooth func-
LIQUIDITY STANDARDS tioning of payment and settlement systems.

In September 2008, the Basel Committee published its Prin- Stress testing
ciples for Sound Liquidity Risk Management and Supervision.
This report is a major update of a 2000 report that was During the turmoil, many banks failed to consider the possibil-
already under way prior to the crisis, but was refocused to ity of a market-wide stress event, such as the inability to fund
highlight the lessons of recent events. It is expected to have an in either unsecured or secured markets. Stress tests and con-
important impact on supervisory practice in the area of liquid- tingency funding plans (CFPs) were designed under an
ity risk. The report sets out 17 fundamental principles for the assumption that a liquidity crisis would be relatively short-
management and supervision of liquidity risk. Here, we note lived. Furthermore, there was a weak connection between
some of the highlights. stress-test results and the shaping of banks CFPs. The Com-
mittee recommends the use of market-wide scenarios cover-
The first principle of liquidity-risk management (LRM) delin- ing longer time horizons in stress tests, as well as the explicit
eates a balance of responsibilities between banks and linkage of stress-test results to CFPs.
supervisors. The bank is responsible for LRM and should have
a risk-management framework that ensures the availability of Disclosure
a stock of liquid assets sufficient to survive a stress environ-
ment.9 The Basel Committee also recommends improved disclosure,
both quantitative and qualitative, of a banks liquidity-risk
Product pricing profile and management framework.

As the crisis unfolded, it became apparent, in many cases, that THE ROLE OF CENTRAL BANKS
banks had not been properly pricing in the costs of liquidity
risk pertaining to certain products and business strategies. By definition, the central bank is the ultimate provider of
liquidity. Central banks provide liquidity in various contexts to
8. The March 2008 Senior Supervisors Group Report on global risk-management promote the stability and efficient functioning of the financial
practices found that, during the turmoil, some financial institutions had trouble system (Chapman and Martin 2007).
identifying their global liquidity position, and others had overly optimistic
assumptions about the availability of foreign exchange swap markets.
9. Bank boards are responsible for establishing the firm-wide risk tolerance; they Indeed, central banks played a key role following the events of
delegate to senior management the powers to establish an infrastructure nec- August 2007 in facilitating the overall level of and distribution
essary to maintain that risk tolerance. Supervisors are responsible for assess-
ing that framework and should intervene in a timely fashion to address of liquidity in the system. During normal times, central banks
observed deficiencies. tend to focus on the aggregate level of liquidity provided to

50 POLICY AND INFRASTRUCTURE DEVELOPMENTS

BANK OF CANADA FINANCIAL SYSTEM REVIEW DECEMBER 2008
banks and, to a much lesser extent, the distribution of liquid- CONCLUSION
ity. During stressed times, central banks give greater empha-
sis to alleviating problems with the distribution of liquidity in Prior to the events of August 2007, liquidity riskarguably
the system through measures intended to be temporary. the most fundamental of all banking risksmay not have been
getting the attention it deserved in some quarters. That is
For banks, access to central bank liquidity is a key component clearly no longer the case. Banks and supervisors are carrying
of their toolkit for liquidity-risk management. But, again, this out an in-depth review of their liquidity practices and proce-
access is normally seen as a source of temporary last-resort dures to ensure that they reflect the realities of todays com-
financingparticularly during times of stressnot as a source plex banking organizations and markets. Central banks are
of permanent funding. reviewing their role in the provision of liquidity during such dif-
ficult times, and ensuring that they have all the tools they
The recent events have underlined the need for central banks might need during such circumstances.
to have more flexibilitywith respect to the permitted terms
and eligible asset classesfor their facilities for providing REFERENCES
liquidity to banks and markets during periods of stress. As an
initial step, the Bank of Canada Act has been revised to permit Aaron, M., J. Armstrong, and M. Zelmer. 2007. An Overview
the Bank to accept a wider range of collateral in its purchase of Risk Management at Canadian Banks. Bank of Canada
and resale (PRA) operations, if circumstances should so war- Financial System Review (June): 3948.
rant.10 This wider range has been used in the term PRA opera-
tions this autumn. Bank of Canada. 2008. Bank of Canada Announces Swap
Facility with U.S. Federal Reserve as Part of Coordinated
Central bank operations are no substitute for sound liquidity- Central Bank Actions. Notice, 18 September.
risk management at banks. As pointed out by the Committee
on the Global Financial System (CGFS): The expectation that Basel Committee on Banking Supervision. 2008a. Liquidity
central banks will act to attenuate market malfunctioning may Risk: Management and Supervisory Challenges. Bank for
create moral hazard by weakening market participants International Settlements (February).
incentives to manage liquidity prudently. Central banks should
carefully weigh the benefits of actions to re-establish liquidity . 2008b. Principles for Sound Liquidity Risk Manage-
against their potential costs and, where necessary, introduce ment and Supervision. Bank for International Settle-
or support safeguards against the distortion of incentives. ments (September).
(CGFS 2008).11
Chapman, J. and A. Martin. 2007. The Provision of Central
The FSF recommendation that central banks share their con- Bank Liquidity under Asymmetric Information. Bank of
tingency plans for liquidity, not only with their supervisors but Canada Financial System Review (December): 8386.
with relevant central banks, is one way of mitigating these
moral hazard concerns. In that context, the Bank of Canada Committee on the Global Financial System (CGFS). 2008.
and the Office of the Superintendant of Financial Institutions Central Bank Operations in Response to the Financial
have initiated an intensified program of collaboration in terms Turmoil. CGFS Papers No. 31 (July).
of collecting and sharing information on the liquidity-risk
practices of banks and on developments in market risk. Crockett, A. 2008. Market Liquidity and Financial Stability.
Banque de France Financial Stability ReviewSpecial Issue
on Liquidity. No. 11 (February): 1317.

Daniel, F., W. Engert, and D. Maclean. 20042005. The Bank

of Canada as Lender of Last Resort. Bank of Canada
10. It is important to note that the large Canadian banks also have extensive for-
eign currency operations. While they have access to Bank of Canada standing Review (Winter): 316.
liquidity facilities and PRA operations to obtain Canadian currency, they are
expected to make arrangements to meet their liquidity needs in all other cur-
rencies relevant to their business. For example, banks with an important Engert, W., J. Selody, and C. Wilkins. 2008. Financial Market
requirement for U.S.-dollar liquidity are expected to have arrangements in Turmoil and Central Bank Intervention. Bank of Canada
place with the Federal Reserves Discount Window. However, given the market
turmoil, the Bank of Canada and the U.S. Federal Reserve have agreed on a Financial System Review (June): 7178.
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Reserve to be accessed, should the need arise, to provide U.S.-dollar liquidity in
Canada (Bank of Canada 2008). Engert, W., T. Gravelle, and D. Howard. 2008. The Implemen-
tation of Monetary Policy in Canada. Bank of Canada
11. See Engert, Selody, and Wilkins (2008) for background as to how the Bank of
Canada provides liquidity to financial institutions and a framework for inter- Discussion Paper No. 2008-9 (July).
vention during times of market turmoil.

POLICY AND INFRASTRUCTURE DEVELOPMENTS

BANK OF CANADA FINANCIAL SYSTEM REVIEW DECEMBER 2008 51
REFERENCES (CONTD)
Financial Stability Forum (FSF). 2008. Report on Enhancing
Market and Institutional Resilience . (April).

Goodhart, C. 2008. Liquidity Risk Management. Banque de

France Financial Stability ReviewSpecial Issue on Liquidity.
No. 11 (February): 3944.

Institute of International Finance (IIF). 2007. Principles of

Liquidity Risk Management. (March).

Matz, L. and P. Neu (eds). 2007. Liquidity Risk Measurement

and Management: A Practitioners Guide to Global Best
Practices. Singapore: John Wiley & Sons (Asia).

Moodys Investors Service. 2002. Bank Liquidity: Canadian

Bank Case Study. Special Comment (December).

52 POLICY AND INFRASTRUCTURE DEVELOPMENTS

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