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Business Risk 2012

Liquidity risk and its management


Antoaneta Georgieva Erasmus student

Business Risk 2012

Introduction
The aim of my paper work is to clarify the actual meaning of liquidity and especially the liquidity risk. Forward I will try to explain what exactly liquidity risk is, the different types of liquidity risk, how managers must understand this type of risk in their companies, how as quick as possible to find the sources which cause this risk and as most important - how to measure and deal with it. Banks must have sufficient liquidity to meet commitments as they fall due. Liquidity risk is the risk that a bank will not have sufficient liquid resources available to meet commitments. Maturing assets might turn out to be non-performing. This may prompt the bank to liquidate other investments. The volume of these other investments liquidated could significantly move the market price of the assets. In extreme cases there might not even be a viable market in which to trade. Risk management plays a central role in institutional investors allocation of capital to trading. Tighter risk management leads to market illiquidity, and this illiquidity further tightens risk management. Tighter risk management leads to more restricted positions, hence longer expected selling times, implying higher risk over the expected selling period, which further tightens the risk management, and so on. This feedback between liquidity and risk management can help explain why liquidity can suddenly drop.

Business Risk 2012

Liquidity risk
Liquidity risk is the current and prospective risk to earnings or capital arising from a banks inability to meet its obligations when they come due without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset-side risk arises from transaction that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit. Liability-side risk arises from transactions whereby a creditor, depositor, or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress. Depository institutions are the FIs most exposed to liquidity risk. Mutual funds, pension funds, and PC insurance companies are the least exposed. In the middle are life insurance companies.

Business Risk 2012

Types of Liquidity risk


1 Central bank liquidity risk A definition for central bank liquidity risk was, to the best of our knowledge, not possible to come up with in the literature. This is mainly because of the widespread view that central bank liquidity risk is non-existent, as the central bank is always able to supply base money and, therefore, can never be illiquid. Typically the central bank, being the monopoly provider of liquidity, i.e. the originator of the monetary base, can dispense liquidity as and when it deems needed, so as to satisfy the equilibrium demand for liquidity in the banking system (avoiding cases of excess liquidity or liquidity deposits) according to its policy stance. A central bank can only be illiquid to the extent that there is no demand for domestic currency, and therefore the supply of base money from the central bank could not materialize. This could happen in cases of hyperinflation or an exchange rate crisis. However, based on conventional wisdom such a scenario could be safely regarded as unlikely, at least in developed, industrialized countries and, therefore, it is not considered in the literature. It would also be useful to stress that a central bank can incur costs in its role as a liquidity provider, but these costs do not necessarily reflect liquidity risk. Such costs can involve central bank specific risks (e.g. counterparty credit risk related to collateral value), monetary policy related risks (e.g. risks of wrong signalling) or wider risks to Financial stability (i.e. the moral hazard issue that relates to emergency liquidity assistance in turbulent periods). Nevertheless, these risks do not aspect the ability of the central bank to provide liquidity. 2 Funding liquidity risk At least since Bagehot (1873) it was known that banks are subject to funding liquidity risk. According to the IMF (2008) funding liquidity risk captures the inability of a Financial intermediary to service their liabilities as they fall due. Other definitions of funding liquidity risk usually involve a time horizon, that is, the probability of becoming illiquid is typically measured for a given period ahead and can differ significantly according to the length of the period (Matz and Neu, 2006; Drehmann and Nikolaou, 2008). Typically, funding liquidity risk depends on the availability of the four liquidity sources and the ability to satisfy the budget constraint over the respective period of time. Measuring funding liquidity risk is not trivial. In most cases practitioners construct various funding liquidity ratios, which reveal different aspects of the availability of funds within a certain time horizon ahead and use them as proxies fonfunding liquidity risk. Such measures can be produced either by static balance sheet analysis or by dynamic stress testing techniques and scenario analysis. The latter is more cumbersome to calculate if only because it relies on complicated calculations and a wider set of information and hypotheses. Recently, Drehmann and Nikolaou (2008) suggest a simple and more straightforward proxy, based on the role of the central bank as a potential funding liquidity

Business Risk 2012


source. They argue that bidding behaviour in central bank auctions can reveal the funding liquidity risk of banks over a one week horizon and construct proxies of funding liquidity risk from bidding data. Academic evidence on the properties of funding liquidity risk is scant. Drehmann and Nikolaou (2008) nd that funding liquidity risk bears similarities to market liquidity risk, in the sense that it is low and stable most of the times, but subject to occasional spikes (e.g. funding liquidity risk appears elevated during the current turmoil period). This Finding is supported by Matz and Neu, (2006), who view liquidity risk as a consequential risk, because it increases following one or more spikes in other nancial risks (i.e. market liquidity risk). Brunnemeier and Pedersen (2007) provide further theoretical support, and rationalise linkages between market and funding liquidity risk (for traders), which are validated empirically by Drehmann and Nikolaou (2008). 3 Market liquidity risk Market liquidity risk relates to the inability of trading at a fair price with immediacy. It is the systematic, non-diversifable component of liquidity risk. This has two important implications. First, it suggests commonalities in liquidity risk across markets. Such commonalities have been grounded theoretically (Brunnemeier and Pedersen, 2005 and 2007) and recorded empirically across stocks and across bonds and equity markets . More extensive propagation mechanisms can also transfer liquidity risk across interbank and asset markets . The second implication of systemic risk is that it should be priced. Namely, market liquidity risk has been typically regarded as a cost or premium in the asset pricing literature, which affects the price of an asset in a positive way thereby influencing market decisions (i.e. optimal portfolio allocation as in Longstaf, 1998) and market practices (i.e. transaction costs as in Jarrow and Subramanian, 1997). In fact, the relationship between liquidity risk and prices can be endogenous, in the sense that there is a two-way causality market liquidity risk. In practical terms, starting with the liquidity-based asset pricing model of Holmstrom and Tirole (2001), asset pricing models typically measure liquidity risk as the covariance (commonality) between a measure of liquidity (innovations) and market returns (Pastor and Staumbaugh, 2003; Acharya and Pedersen, 2005; Liu, 2006). Liquidity risk commoves with contemporaneous returns, but it is also possible to predict future returns based on current liquidity risk estimates (Chordia et al., 2001; Acharya and Pedersen, 2005; Liu, 2006). Overall, the related literature suggests that asset prices reflect liquidity costs, which are linked to the existence of liquidity risk. The behaviour of market liquidity risk (i.e. of the market liquidity premium) has also been recorded. Liquidity risk is in most cases low and stable. Elevated liquidity risk is rare and episodic (see empirical evidence in equity market in Pastor and Staumbaugh, 2003). The episodic nature can result from downward liquidity spirals due to mutually reinforcing funding and market illiquidity (Brunnemeier and Pedersen, 2005 and 2007) and is rare because of benefits from cooperation in trading (Carlin et al., 2007). On this latter point, Brusco and Castiglinesi (2007) further argue that Financial links are established only when the benefits are greater than the costs, that is, when the possibility of a financial crisis (and therefore elevated liquidity risk) is limited. As a consequence, crises and financial contagion are rare events. Given this behaviour of market liquidity risk, it is possible to understand why liquidity is time varying and persistent in smooth periods (Amihud, 2002; Chordia et al., 2000,2001,2002; Pastor and Staumbaugh, 2003).

Business Risk 2012


Finally, the implications of market (systemic) liquidity risk are important from a financial stability point of view. In fact, individual liquidity risk (leading to single bank failures) might not be of consequence, and indeed might even be a helpful mechanism to restore financial health in certain parts of the system (Diamond and Dybvig, 1983; Allen and Gale, 1998). However, systemic (market) liquidity risk can have serious repercussions for the financial system as a whole. Notably, it leads to financial crises, which damage financial stability, disrupt the allocation of resources and ultimately, affect the real economy (Hoggarth and Saporta, 2001; Ferguson et al., 2007). Given the importance of market liquidity risk (i.e. systemic risk) to financial stability, it is the type of liquidity risk that immediately alerts policy makers. Nevertheless, given the intense linkages among the various liquidity types, a general view of the liquidity flows in the system is also needed to examine market liquidity risk.

Business Risk 2012

Protecting the company against liquidity risk

There are several ways you can help protect the company from liquidity risk. These include:

Never buy long-term investments that are illiquid unless you can afford to hold them through terrible recessions and job loss. If you might need cash in six months, don't buy 5year certificate of deposits or an apartment building. Remember that your total debt is less important as the amount of excess cash you have after making your debt payments each month. Fixed payments of $5,000 per month are overwhelming to someone with $6,000 per month in take-home pay. The same payments are a rounding error to someone making $300,000 per month. All else being equal, the bigger the cushion between the cash you earn each month and the cash you pay out, the less the chance you get caught in a liquidity risk crisis. Avoid investing in companies that are facing potential liquidity risk. Is there any big debt refinancing plans that could risk the company's well-being? Does the company have a solid balance sheet with long-term funding sources, such as shareholder equity instead of shortterm deposits? If you don't understand what this means, you should probably stick to lowcost, widely diversified index funds.

Business Risk 2012

Liquidity characteristic of assets

Liquid assets are among the most basic form of financial resources used by consumers suppliers and investors. Essentially, a liquid asset is cash or any type of negotiable asset that can be converted quickly and easily into cash. In many instances, financial experts choose to classify liquid assets as any asset that can be converted into cash within a period of twenty days. Currency and coin are the two most obvious forms of liquid assets. Immediately recognized as legal tender for purchases and to settle outstanding debts, currency remains the single most common of all liquid assets that are used on a consistent basis by retail customers. The circulation of currency and coins are controlled by the financial arm of the country in question, often a treasury or revenue department of the central government. Along with currency, there are several other common examples of liquid assets that are used both in business and in the private sector. Money that is deposited into a savings or checking account are considered to be liquid assets, since it is possible to immediately access the funds and issue them in order to settle debts. With the advent of the debit card, the consumer has even greater access to immediate liquid assets of this type than ever before. The standard savings account is not the only form of investment that can be properly classified as a liquid asset. Money market fund shares, bonds, mutual funds, and the cash value of a life insurance policy are all examples of interest bearing investments that can undergo liquidation provide quick cash when necessary. While the actual market liquidity of each asset may vary, the key is that the process of converting or selling off the asset to raise money will be simple and can be accomplished in a short period of time. Other forms of the cash asset may apply in different business and personal finance situations. Mortgages are sometimes considered a liquid asset. The final settlement awarded by a court for damages in a lawsuit are considered to be liquid assets, depending on the terms of payment specified by the court. Tax refunds and the balances of trust funds are often also included in the working definition for liquid assets. When determining if a particular asset is in fact a liquid one, keep in mind that the asset must be one that can be sold for cash quickly and realize a sale value that is at least equal to the market value of the asset.

Business Risk 2012

Sources of Liquidity Risk


Liquidity risk emanates from the nature of banking business, from the macro factors that are exogenous to the bank, as well as from the financing and operational policies that are internal to the banking firm. In case of Islamic banks the nature of sharia compatible contracts are an additional source of liquidity risk, particularly if the conventional financial infrastructure is maintained. Banks provide maturity transformation. Taking deposits that are callable on demand or that on average has shorter maturity than the average maturity of the financing contracts they sell. While maturity transformation provides liquidity insurance to the depositors, which is valued by them, it exposes banks to liquidity risk themselves. Since banks specialize in maturity transformation they take pool deposits and take care to match their cash inflows and outflows in order to address the liquidity risk they face. However, maturity mismatch at a given time is not the only source of liquidity risk. The risk of this kind can arrive from many directions and its pinch depends on various factors. In a nutshell its sources (i) on assets side depends on the degree of inability of bank to convert its assets into cash without loss at time of need, and (ii) on liabilities side it emanates from unanticipated recall of deposits. Using the categorization in Jameson (2001) and adding a few more we can break them into following behavioral and exogenous sources: 1. Incorrect judgment or complacent attitude of the bank towards timing of its cash in- and out-flows. 2. Unanticipated change in the cost of capital or availability of funding. 3. Abnormal behavior of financial markets under stress. 4. Range of assumptions used in predicting cash flows. 5. Risk activation by secondary sources such as: i. Business strategy failure ii. Corporate governance failure iii. Modeling assumptions iv. Merger and accusations policy 6. Breakdown in payments and settlement system 7. Macroeconomic imbalances The second source of liquidity risk listed above stems from the unanticipated difference in the realized and assumed availability of funding, marketability of its assets or their use 3as collateral in raising funds quickly, and the amount of haircut anticipated. This can happen due to causes general to the banking sector or specific to the bank. Sometimes a major bank (money center), on whom the smaller bank(s) rely, would experience a credit squeeze or a rating downgrade thus affecting the funds availability to the other banks. The third factor, behavior of the capital markets in stressed condition, lies outside the control of a bank but it does have implications for liquidity of banks.

Business Risk 2012


First adverse movements in the capital markets change the availability of funds to the bank if it desires to raise it through them. Second, increasing reliance by the banks on whole sale markets rather than small depositors affects the composition of risk sensitive market savvy depositors in the depositor pool of the bank. These depositors are quick to move funds away form the bank at the first signs of trouble, thus increasing the probability of a run on the bank or a liquidity problem. The fourth factor is not a cause in itself but determines the preparedness of the bank to liquidity shocks. Larger the number of scenarios and range of assumptions for which a bank has stress tested its strategies against liquidity crisis greater is the likelihood of smooth management of the risk. The fifth source is most difficult to envisage ex ante where a potential exposure to a liquidity risk is activated by a secondary risk source (Jameson 2001, p.2). Current examples of such happenings include that of collapse of General American in 1999 and Long Term Capital Management (LTCM). The former closed down because it concentrated on short-term instruments for its funding needs and had heavily relied on a few (37) market sensitive institutional investors (money market mutual funds) for its funding. All other things were very fine with General American. The financial problems started elsewhere in an outside company which was providing re-insurance facility to it. Responding to this, General American made a business move and recaptured the reinsurance portfolio thereby self insuring all its obligations. As soon as the rating of General American was down graded because of its self insurance move, the institutional investors started recalling their funds creating a liquidity problem for it. General American was quickly assassinated within days. Fragile and unreliable payments and settlement system is the sixth source of liquidity risk. Smooth operations of the banking sector and financial markets depend on sound operation of this system. A break down can trigger liquidity problems not only for a single bank but also for the entire banking and financial sector thus resulting in a generalized financial crisis. Macroeconomic imbalances and sector wide shocks are another avenues giving rise to liquidity risk. These factors are particularly important in developing countries. Excessive government borrowing from domestic markets and banks increases cost of funding for the banks. In many restrictive environments it gives rise to financial repression where banks are required to finance government expenditures at less than the market price. In some cases the excessive government borrowing is accomplished by creating funding arbitrage leading to disintermediation banks generating funds from cheaper sources and channeling them into short-term high return government securities. In all such circumstances liquidity risk of the banks increases substantially either involuntarily or voluntary by changing the composition of asset portfolio of the bank. Then, any shock to the system can create liquidity problems for individual banks and for the banking sector as a whole. Fiscal imbalances are not the only macroeconomic source of liquidity risk. Persistent current or capital account imbalances, large savings and investment gap, high inflation all

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can lead to similar risks. Eighth source of liquidity risk in our above list stems from contractual forms of Islamic finance. Since we want to focus on it and it is new area that requires some explanation we discuss them in the following sub-section.

The maturity ladder


The usual way to measure liquidity requirements is by means of a liquidity ladder. Currency by currency, all liabilities and assets are placed by reference to their ultimate maturity date. When calculating liquidity ladders, there are a number of issues that the bank must consider: - What proportion of current and savings accounts are likely to be withdrawn on demand or at short notice? - What percentage of overdrafts will never be repaid or will have to be transformed into long-term loans? - Undrawn lending commitments: how much of these are likely to be drawn down at short notice? - How many loans are non-performing? A maturity ladder should be used to compare a bank's future cash inflows to its future cash outflows over a series of specified time periods. Cash inflows arise from maturing assets, saleable non-maturing assets and established credit lines that can be tapped. Cash outflows include liabilities falling due and contingent liabilities, especially committed lines of credit that can be drawn down. In Table 1, the maturity ladder is represented by placing sources and amounts of cash inflows on one side of the page and sources and amounts of outflows on the other. In constructing the maturity ladder, a bank has to allocate each cash inflow or outflow to a given calendar date from a starting point, usually the next day. (A bank must be clear about the clearing and settlement conventions it is using to determine its initial point.) As a preliminary step to constructing the maturity ladder, cash inflows can be ranked by the date on which assets mature or a conservative estimate of when credit lines can be drawn down. Similarly, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option, or the earliest date contingencies can be called. Significant interest and other cash flows should also be included. The difference between cash inflows and cash outflows in each period, the excess or deficit of funds, becomes a startingpoint for a measure of a bank's future liquidity excess or shortfall at a series of points in time. It is this net funding requirement that requires management. Typically, a bank may find substantial funding gaps in distant periods and will endeavour to fill these gaps by influencing

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the maturity of transactions so as to offset the gap. For example, if there is a significant funding requirement 30 days hence, a bank may choose to acquire an asset maturing on that day, or seek to renew or roll over a liability. The closer a large gap gets, the more difficult it is to offset. Thus, banks will typically collect data on relatively distant periods so as to maximise the opportunities to close the gap before it gets too close. Most banks would regard it as important that any remaining borrowing requirement should be limited to an amount which experience suggests is comfortably within the bank's capacity to fund in the market.

Risk Measurement
It is recommended that the credit union measure the performance and risk level of the liquidity portfolio and report these findings to the board. Risk Measurement The following are minimum risk and performance measures of liquidity management, required by sound business and financial practices: the volume of liquid assets, relative to the plan and to historic levels, and compared against regulatory requirements; the average liquidity yield; the amount of short term borrowings (i.e. less than 100 days); identification of large deposits The credit union must comply with any liquidity related measurement requirements set out in the Act and Regulations. The credit union may track any other measures of the liquidity portfolio as it sees fit. These measurements should be compared to financial targets in the annual business plan and the budget, so that management can determine whether the credit union is meeting its goals. Management can also assess whether there are material variances from the plan which need to be addressed. Comparison of these measurements against historical performance, where possible, can also identify significant trends which may need to be addressed by management. Risk Measurement Techniques Due to the similarities between the investment portfolio and liquidity portfolio, the techniques used to measure liquidity risk are the same as the techniques used to measure investment risk. Therefore, the discussion on risk measurement techniques in Section 6401 should be referred to when developing risk measurement techniques for liquidity management.

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Board Reports The measurements of liquidity risk discussed earlier should be reported to the board of directors, so that the board can also monitor the liquidity portfolio and ensure adherence to regulatory requirements and to the annual business plan. Material variances from plan and their causes, as well as management's plan to correct the variance, should also be included in the report. Management should also provide the board with a summary on compliance with liquidity policy and relevant regulatory requirements. Frequency Management should provide the board with a report on the liquidity portfolio for each board. Risk management Corrective Action An important activity in the effective management of risk is management's timely response to unathorized risk or poor performance developments. As a follow up to the liquidity risk measurements taken by the credit union (discussed in Section 8400), management should investigate all significant performance variances relative to the annual business plan and to historical performance, and respond by taking action to correct these variances. Management must similarly respond to any contravention of board policy or regulatory requirements, or other unauthorized risk. Operational Procedures It is recommended that credit unions have procedures in place which will ensure compliance with: minimum liquidity requirements, set out both in legislation and in board policy; minimum investment quality limits, set out both in legislation and in board policy; and that large deposits are properly hedged or matched, so that operational liquidity will not be greatly affected if these deposits were withdrawn. To assist in implementation, procedures should be both appropriate and cost effective given the size of the credit union's operations. It is a sound business and financial practice for credit unions to document procedures. Written procedures result in higher staff productivity and better control over resources. Monitoring Liquidity Needs The credit union's liquidity needs should be reviewed on a periodic basis. For most credit unions, this will mean at least on a weekly basis. This review should encompass a detailed forecast of imminent liquidity requirements and a broad projection of cash needs for the next three month period. Summary measurements of liquidity needs should be prepared for board review at each board meeting.To determine immediate cash flow needs, a cash flow statement can be used to develop projections for the next three months. Periodic (weekly or monthly)

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cash flow projections can predict whether excess or deficient liquidity levels will be experienced by the credit union in the near future. If deficiencies are below operational levels, management will have to take action to correct these levels. Liquidity Shortages Whenever deficient liquidity levels are discovered, management must prepare marketing and financial strategies to align liquidity levels within desired targets, or take defensive actions. Defense actions to protect the liquidity position of a credit union would normally include: marketing measures to improve deposit levels; judicious use of standby lines of credit; judicious use of borrowings for liquidity support; temporary curtailment of lending; sale of assets to a third party. It should be recognized that the above noted defense actions are listed in order of most attractive to least attractive option. Curtailment of lending activity is considered least desirable because of the negative effect on member confidence, however, certain restrictions on lending may become a necessary trade-off in a liquidity crisis. Early reaction, in terms of moderate or temporary curtailment of lending, will often overcome the need for drastic measures at some later stage. Alternative liquidity defense strategies such as an available overdraft facility and an approved line of credit facility with a league or chartered bank are recommended sound business and financial practices. The use of an overdraft facility permits a credit union to maximize the value of its float without jeopardizing the clearance of its negotiable instruments. One example of an aggressive cash management strategy would be to make the greatest possible use of short term call deposits in the money market while permitting the current account to be in occasional overdraft position, in order to maximize earnings. Excess Liquidity Where a credit union has significant liquidity in excess of statutory requirements due to unanticipated net cash inflow, management should examine options to reduce liquidity to an appropriate level. High levels of liquidity generally have an unfavourable effect on profitability, as the rate of return earned on short-term investments is usually not as high as the yield on loans, and cash held in the credit union earns no interest. In order to reduce liquidity which is in excess of operational requirements, management should ensure it has exhausted all credit granting opportunities, without compromising on credit quality. Alternatively, the credit union should undertake membership drives to expand loan demand. Where the promotion of credit does not fully utilize excess liquidity, interim investment of funds should generally be made in short-term investments, so that conversion to new loans may readily occur. During an economic downturn or in situations where aging member demographics are difficult to reverse, board and management may determine that a portion of excess liquidity is likely to persist for longer than the current fiscal period. In such situations, management should look for safe investments with terms in excess of one year that would generate higher yields.

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Quality of Liquidity Risk Management


The following indicators, as appropriate, should be used when assessing the quality of liquidity risk management. Strong Board approved policies effectively communicate guidelines for liquidity risk management and designate responsibility. The liquidity risk management process is effective in identifying, measuring, monitoring, and controlling liquidity risk. Reflects a sound culture that has proven effective over time. Management fully understands all aspects of liquidity risk. Management anticipates and responds well to changing market conditions. The contingency funding plan is well-developed, effective and useful. The plan incorporates reasonable assumptions, scenarios, and crisis management planning, and is tailored to the needs of the institution. Management information systems focus on significant issues and produce timely, accurate, complete, and meaningful information to enable effective management of liquidity. Internal audit coverage is comprehensive and effective. The scope and frequency are reasonable. Satisfactory Board approved policies adequately communicate guidance for liquidity risk management and assign responsibility. Minor weaknesses may be present. The liquidity risk management process is generally effective in identifying, measuring, monitoring, and controlling liquidity. There may be minor weaknesses given the complexity of the risks undertaken, but these are easily corrected. Management reasonably understands the key aspects of liquidity risk. Management adequately responds to changes in market conditions. The contingency funding plan is adequate. The plan is current, reasonably addresses most relevant issues, and contains an adequate level of detail including multiple scenario analysis. The plan may require minor refinement.

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Management information systems adequately capture concentrations and rollover risk, and are timely, accurate, and complete. Recommendations are minor and do not impact effectiveness. Internal audit is satisfactory. Any weaknesses are minor and do not impair effectiveness or reliance on audit findings. Weak Board approved policies are inadequate or incomplete. Policy is deficient in one or more material respects. The liquidity risk management process is ineffective in identifying, measuring, monitoring, and controlling liquidity risk. This may be true in one or more material respects, given the complexity of the risks undertaken. Management does not fully understand, or chooses to ignore, key aspects of liquidity risk. Management does not anticipate or take timely or appropriate actions in response to changes in market conditions. The contingency funding plan is inadequate or nonexistent. Plan may exist, but is not tailored to the institution, is not realistic, or is not properly implemented. The plan may not consider cost-effectiveness or availability of funds in a non-investment grade or CAMEL 3 environment. Management information systems are deficient. Material information may be lacking or inaccurate, and reports are not meaningful. Internal audit coverage is nonexistent or ineffective due to one or more material deficiencies.

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Planning
Annually, management and the board of directors must develop an business plan for the credit union, summarizing the credit union's goals and objectives for the coming year. This annual business plan includes a strategic financial plan that addresses each area of risk management, including liquidity. As part of the strategic financial plan, management and the board must set financial targets and plans for liquidity management. 1. Short-term Planning 2. Long-term Planning: A. Forecast liquidity needs over next 1-2 years B. Identify Liquidity Gap C. Compare Potential Funding Sources and Extraordinary Funding Needs

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Conclusion
Liquidity risk, which is both idiosyncratic and systemic in nature, has been neglected for quite some time and only recently have regulators come to realize the crucial role played by liquidity risk in the risk landscape of a banking entity and the entire industry. Senior management needs to strike a thoughtful balance between risk and profit appetites. As liquidity risk varies across time, assets and liability segments (including instrument class, industry, geography and jurisdictions); stress testing and the use of scenario techniques will help banks identify gaps in the implementation of their liquidity risk management practices. Though liquidity risk is not new to the banking industry, this pioneering regime to manage and monitor liquidity risk under both "business-as-usual" scenarios and stress scenarios, is. With the key mandate of this regime being to protect the interests of all institutional stakeholders (including debtors, owners and lenders) by way of close supervision on an ongoing basis, institutions will need to address these requirements at home and around the globe within the prescribed timelines. Banks that regulatory guidelines such as these will continue to evolve and change over time and with local and global market conditions. Furthermore, being a principle-oriented regulation and with most of the provisions in the form of guidance, senior management must now come to the realization that the responsibility of their liquidity judgments will be of far greater significance and consequence than previously seen.

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References
http://pages.stern.nyu.edu/~lpederse/papers/LiquidityRiskManagement.pdf http://beginnersinvest.about.com/od/Risk-Management/a/Liquidity-Risk-101.htm

http://www.bankofcanada.ca/wp-content/uploads/2011/05/gauthier.pdf http://www.wisegeek.com/what-are-liquid-assets.htm

http://www.sbp.org.pk/departments/ibd/Lecture_6_Islamic_Modes_Finance_Liquidity.p df http://riskinstitute.ch/139330.htm

http://www.dico.com/design/SBFP_En/Liquidity%20Risk%20Management%20(Liquidity) .pdf

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