liquidity management

FOCUS ON LIQUIDITY MANAGEMENT

INTRODUCTION

We often hear the word liquidity used in combination with cash management. Liquidity is a firm's ability to pay its short-term debt obligations. In other words, if the firm has adequate liquidity, it can pay its current liabilities such as accounts payable. Usually, accounts payable are debts owe to our suppliers.

There are methods we can use to measure liquidity. Financial ratio analysis will help us determine how liquid firm is or how successful it will be in meeting its short-term debt obligations. The current ratio will help us determine the ratio of current assets to current liabilities. Current assets include cash, accounts receivable, inventory, and occasionally other line items such as marketable securities. We need to have more current assets than current liabilities on our balance sheet at all times.

The quick ratio will allow determining if we can pay your short-term debt obligations, or current liabilities, without having to sell any inventory. It's important for a firm to be able to do this because, if we sell have to sell inventory to pay bills that means we have to find a buyer for that inventory. Finding a buyer is not always easy or possible.

There is various other measure of liquidity that you will want to use to determine our cash position.

When your business is just starting up, we essentially run it out of a check book, which is an example of cash accounting. As long as there is cash in the account, our business is solvent. As business becomes more complex, we will have to adopt financial accounting. However, we have to keep a focus on liquidity and cash management even though our track net income through financial accounting.

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PURPOSE

This document sets out the minimum policies and procedures that each institution needs to have in place and apply within its liquidity management programme, and the minimum criteria it should use to prudently manage and control its liquidity. Although this document focuses on the institution’s responsibility for managing liquidity, and is intended to address liquidity management within the context of a strategic liquidity plan under ordinary or reasonably expected business conditions, liquidity management cannot be conducted in isolation from other asset/liability management considerations, such as interest and foreign exchange rate risk, or other risks. However, since liquidity determines the day-to-day viability of an institution, it must remain the principal consideration of asset/liability management. Moreover, this document presents the management of liquidity undifferentiated as to currency denomination, since in principle, through the foreign exchange markets, commitments in one currency may be met by the availability of funds in another. However, institutions that conduct substantial business in foreign currencies need to make distinctions between the management of liquidity in domestic currency (Jamaican dollars) and that in other currencies.

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DEFINITION

Liquidity is the availability of funds, or assurance that funds will be available, to honour all cash outflow commitments (both on- and off-balance sheet) as they fall due. These commitments are generally met through cash inflows, supplemented by assets readily convertible to cash or through the institution’s capacity to borrow. The risk of illiquidity may increase if principal and interest cash flows related to assets, liabilities and off-balance sheet items are mismatched.

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LIQUIDTY MANAGEMENT PROGRAMME

Managing liquidity is a fundamental component in the safe and sound management of all financial institutions. Sound liquidity management involves prudently managing assets and liabilities (on- and off-balance sheet), both as to cash flow and concentration, to ensure that cash inflows have an appropriate relationship to approaching cash outflows. This needs to be supported by a process planning which assesses potential future liquidity needs, taking into account changes in economic, regulatory or other operating conditions. Such planning involves identifying known, expected and potential cash outflows and weighing alternative asset/liability management strategies to ensure that adequate cash inflows will be available to the institution to meet these needs. The objectives of liquidity management are:

honouring all cash outflow commitments (both on- and off-balance sheet) on an ongoing, daily basis;

avoiding raising funds at market premiums or through the forced sale of assets; and

satisfying statutory liquidity and statutory reserve requirements.

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Although the particulars of liquidity management will differ among institutions depending upon the nature and complexity of their operations and risk profile, a comprehensive liquidity management programme requires:

establishing and implementing sound and prudent liquidity and funding policies; and

developing and implementing effective techniques and procedures to monitor, measure and control the institution’s liquidity requirement and positions

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Liquidity Policies in Banks

Sound and prudent liquidity policies set out the sources and amount of liquidity required to ensure it is adequate for the continuation of operations and to meet all applicable regulatory requirements. These policies must be supported by effective procedures to measure, achieve and maintain liquidity. Operating liquidity is the level of liquidity required to meet an institution’s day-to-day cash outflow commitments. Operating requirements are met through asset/liability management techniques for controlling cash flows, supplemented by assets readily convertible to cash or by an institution’s ability to borrow. Factors influencing an institution’s operating liquidity include:

cash flows and the extent to which expected cash flows from maturing assets and liabilities match; and

The diversity, reliability and stability of funding sources, the ability to renew or replace for regulatory purposes an institution is required to hold a specific amount of assets classed as “liquid”, based on its deposit liabilities. Generally, undue reliance should not be placed on these assets, or those formally pledged, for operating purposes other than as a temporary measure, as legally they may not be available for encashment if needed.

In assessing the adequacy of liquidity, each institution needs to accurately and frequently measure:

the term profile of current and approaching cash flows generated by assets and liabilities, both on- and off-balance sheet;

the extent to which potential cash outflows are supported by cash inflows over a specified period of time, maturing or liquefiable assets, and cash on hand;

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the extent to which potential cash outflows may be supported by the institution’s ability to borrow or to access discretionary funding sources; and

The level of statutory liquidity and reserves required and to be maintained.

Essentially, operating liquidity is adequate if the institution’s approaching cash inflows, supplemented by assets readily convertible to cash or by an institution’s ability to borrow are sufficient to meet approaching cash outflow obligations. In this context, because the timing and amount of these cash flows are not completely predictable because of risks such as credit defaults, and events including honouring customer drawdowns on credit commitments, deposit redemptions, and prepayments, either on mortgages or term loans, sound and prudent liquidity policies must deal with this uncertainty by carefully controlling the maturity of assets, ensuring assets are readily convertible to cash, or securing sources to borrow funds. Liquid assets should have the following attributes:

diversified, residual maturities appropriate for the institution’s specific cash flow needs;

readily marketable or convertible into cash; and

minimal credit risk.

Holding assets in liquid form for liquidity purposes will often involve some loss of earnings capacity relative to other investment opportunities. Nevertheless, the primary objective with respect to managing the liquid asset portfolio is to ensure its quality and convertibility into cash.

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Funding Policies

Deposit liabilities are the primary source of funding for all institutions. In this context, an important element of an institution’s liquidity management programme is the diversification of funding by origination and term structure. Each institution needs to have explicit and prudent policies that ensure funding is not unduly concentrated with respect to:

individual depositor;

type of deposit instrument;

market source of deposit;

term to maturity; and

currency of deposit, if the institution has liabilities (both on- and off-balance sheet) in foreign currencies.

The primary funding risk is the unplanned deposit withdrawal or the reduced rate of deposit renewal at the time of maturity. Deposits may decline due to a loss of confidence in the institution, a general decline in savings, more attractive investments elsewhere, or as a result of other factors. Concentrated funding sources leave the institution open to potential liquidity problems as a result of such unexpected deposit withdrawal and may also restrict an institution’s flexibility in managing its cash flow. Institutions with excessive funding concentrations may require additional liquid assets. In the context of foreign currency deposits, funding policies also need to ensure that foreign currency cash flows are prudently managed and controlled within the policies and procedures set out under the institution’s foreign exchange risk management programme.

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Liquidity Management and Control Procedures

Each licensee needs to develop and implement effective and comprehensive procedures and information systems to manage and control liquidity in accordance with its liquidity and funding policies. These procedures must be appropriate to the size and complexity of the institution’s liquidity and funding activities. Internal inspections/audits are a key element in managing and controlling an institution’s liquidity management programme. Each institution should use them to ensure that liquidity management complies with liquidity and funding policies and procedures. Internal inspections/audits should, at a minimum, randomly test all aspects of liquidity management in order to:

ensure liquidity and funding policies and procedures are being adhered to;

ensure effective controls apply to managing liquidity;

verify the adequacy and accuracy of management information reports; and

ensure that personnel involved in the liquidity management fully understand the institution’s liquidity and funding policies and have the expertise required to make effective decisions consistent with the liquidity and funding policies.

Assessments of the liquidity management operation should be presented to the institution’s Board of Directors on a timely basis for review.

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ROLE OF THE BOARD OF DIRECTORS

The Board of Directors of each institution is ultimately responsible for the institution’s liquidity. In discharging this responsibility, a Board of Directors usually charges management with developing liquidity and funding policies for the board’s approval, and developing and implementing procedures to measure, manage and control liquidity within these policies. A Board of Directors needs to have a means of ensuring compliance with the liquidity management programme. A Board of Directors generally ensures compliance through periodic reporting by management and internal inspectors/auditors. The reports must provide sufficient information to satisfy the Board of Directors that the institution is complying with its liquidity management programme. At a minimum, a Board of Directors should:

review and approve liquidity and funding policies based on recommendations by the institution’s management;

review periodically, but at least once a year, the liquidity management programme;

ensure that an internal inspection/audit function reviews the liquidity and funding operations to ensure that the institution’s policies and procedures are appropriate and are being adhered to;

ensure the selection and appointment of qualified and competent management to administer the liquidity management function; and

outline the content and frequency of management liquidity reports to the board.

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ROLE OF MANAGEMENT

The management of each institution is responsible for managing and controlling the day-to-day liquidity of the institution according to the liquidity management programme. Although specific liquidity management responsibilities will vary from one institution to another, management should be responsible for:

developing and recommending liquidity and funding policies for approval by the Board of Directors;

implementing the liquidity and funding policies;

ensuring that liquidity is managed and controlled within the liquidity management and funding management programmes;

ensuring the development and implementation of appropriate reporting systems

establishing and utilizing a method for accurately measuring the institution’s current and projected future liquidity;

monitoring economic and other operating conditions to forecast potential liquidity needs;

ensuring that an internal inspection/audit function reviews and assesses the liquidity management programme

developing lines of communication to ensure the timely, dissemination of the liquidity; and

reporting comprehensively on the liquidity management programme to the Board of Director is at least once a year.

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BANK LIQUIDITY

Liquidity for a bank means the ability to meet its financial obligations as they come due. Bank lending finances investments in relatively illiquid assets, but it fund its loans with mostly short term liabilities. Thus one of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions.

Asset Management Banking

Commercial banks differ widely in how they manage liquidity. A small bank derives its funds primarily from customer deposits, normally a fairly stable source in the aggregate. Its assets are mostly loans to small firms and households, and it usually has more deposits than it can find creditworthy borrowers for. Excess funds are typically invested in assets that will provide it with liquidity such as Fed funds loaned and U.S. government securities. The holding of assets that can readily be turned into cash when needed, is known as asset management banking.

Liability Management Banking

In contrast, large banks generally lack sufficient deposits to fund their main business -- dealing with large companies, governments, other financial institutions, and wealthy individuals. Most borrow the funds they need from other major lenders in the form of short term liabilities which must be continually rolled over. This is known as liability management, a much riskier method than asset management. A small bank will lose potential income if gets its asset management wrong. A large bank that gets its liability management wrong may fail.

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Key to Liability Management

The key to liability management is always being able to borrow. Therefore a bank's most vital asset is its creditworthiness. If there is any doubt about its credit, lenders can easily switch to another bank. The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble. If there is serious doubt, it will be unable to borrow at any rate, and will go under. In recent years, large banks have been making increasing use of asset management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds.

Bank Runs

A bank run is an overwhelming demand for cash by a bank's depositors. With the advent of deposit insurance, bank runs by small depositors are largely a thing of the past. Insurance is limited to RS 50, 00,000 per deposit, which provides complete coverage to about 99% of all depositors. But it covers only about three-fourths of the total amount of deposits because many accounts far exceed the insurance limits.

A large depositor assumes a risk and needs to know something about the bank's own balance sheet. However a healthy balance sheet does not eliminate all risk. Even if the depositor knows the bank has adequate liquidity, others may not. Large depositors must therefore be concerned about what others are likely to believe. A rumor about a bank, even though unfounded, can trigger a run that causes a solvent bank to fail.

Possible Solutions

The problems with deposit insurance could be solved by restricting its coverage to risk-free narrow banks or narrow deposits. A narrow bank would offer checking deposits and would be allowed to invest only in safe liquid assets such as T-bills. It could operate as a separate

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institution or as a subsidiary of a bank holding company. Only narrow banks would be eligible for deposit insurance.

Narrow deposits would be checking deposits that could be offered by any licensed institution on condition that they were secured exclusively by safe liquid assets. Only narrow deposits would be eligible for deposit insurance. Thus narrow banks or narrow deposits would be fully collateralized, and deposit insurance would be redundant and unnecessary. Ending deposit insurance would greatly reduce the moral hazard problem in banking.

Importance of liquidity management

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The three basic importance of liquidity management are as follows:

1. BACKGROUND

The overhaul of the country’s Payments System by the Reserve Bank of India is bringing about structural and operational changes which will have a profound effect on the way banks do business and in particular would effect the treasury departments of the banks and on the way they manage intra-day liquidity. These changes will create a need for measurement of payment flows, use of queuing techniques to regulate payment flows, better communications, and a generally higher awareness by treasury managers of payments processing.

2. COMPLEXITY AND IMPACT

The problem of liquidity management is also made more complex because the treasury/funds management departments in banks would be connecting to different payment infrastructures (RTGS, NDS-SSS, FX etc) and this will necessitate the management of multiple intra-day liquidity positions. Banks would be required to put in processes, procedures and Information Technology systems to establish liquidity and operational bridges between these various infrastructure and systems.

3. LIQUIDITY ISSUES

The causes of liquidity fragmentation can be broadly classified into the following categories: operational, technical, policy and bank procedure. It should be noted that the first three classifications refer to the operations of the payments system while the last refers to the actual use of the system by participating banks. However, even in this scenario of ‘liquidity pools’ if banks stick to ‘the rules of the game’ and implement best practices there should be very few payment problems such as gridlocks, end of day positions and liquidity swaps.

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The Liquidity Management Process -

Effective liquidity management requires three-steps in which treasury identifies, manages and optimizes liquidity. These steps are interdependent, each requiring the successful implementation of the other two to optimally manage liquidity.

Identifying liquidity is the foundation from which the entire liquidity management process depends. It involves understanding the balances and positions of the institution on an enterprise-wide level. This requires the ability to access and gather information across the institution's many lines of business, currencies, accounts and, often, multiple systems. Identifying liquidity is primarily a function of data gathering, and does not include the actual movement or usage of funds.

Managing liquidity within a bank's corporate treasury involves using the identified liquidity to support the bank's revenue generating activities. This may include consolidating funds, managing the release of funds to maximize their use, and tasks that "free up" lower-costing funds for lending or investment purposes to maximize their value to the institution.

Optimizing liquidity is an ongoing process with a focus on maximizing the value of the institution's funds. As the strategic aspect of liquidity management, optimizing liquidity balances requires a strong and detailed understanding of the financial institution's liquidity positions across all currencies, accounts, business lines and counterparties. With this information, the bank's treasury is able to map the strategic aspects of the institution into the liquidity management process.

The biggest challenge in the liquidity management process is the limited time and resources available to treasury.

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Basic steps for liquidity management-

How companies are implementing steps to improve their liquidity management using these three steps:

1. Improve visibility with centralized payment workflow & approval

2. Reduce costs with electronic execution of payments

3. Reduce fraud and erroneous payments

The economic downturn is affecting how financial institutions manage liquidity in a number of ways. It has particularly affected the liquidity of financial instrument portfolios, which now need to be thoroughly reappraised.

This indicates the present scenario of liquidity management-

Liquidity management procedures are inadequate, and restrictions are obsolete and prevent business from going forward

The existing level of control over liquidity and cash flows is no longer sufficient

Additional volume of liquid reserves needs to be attracted to close the liquidity gap

Liquidity contingency plans are not realistic in the current

market conditions

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Interest Rate & Liquidity Management

Secondary market transactions are conducted to achieve the desired interest rate risk profile. In addition, liquidity management aims to minimize liquidity costs on the condition that the bank is able to satisfy their refinancing requirements at any time, and to fulfill contractual payment obligations. To manage liquidity, a precise knowledge of future cash flows is required.

Enterprise Content Management (ECM) solutions from Open Text for interest rate & liquidity management deliver this functionality with the following components:

The economic downturn is affecting how financial institutions manage liquidity in a number of ways. It has particularly affected the liquidity of financial instrument portfolios, which now need to be thoroughly reappraised.

If a situation arises

Liquidity management procedures are inadequate, and restrictions are obsolete and prevent business from going forward

The existing level of control over liquidity and cash flows is no longer sufficient

Additional volume of liquid reserves needs to be attracted to close the liquidity gap

Liquidity contingency plans are not realistic in the current market conditions

Fair value and maturity of assets as well as conditional liabilities that could materialise in the current environment need to be identified Quick decision making often fails to follow the even faster economic environment

The end-of-the-day report, uploaded from the IT system, is always late

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ALM and risk management teams fail to collaborate

Our Financial Services Advisory Group can help financial institutions get a more realistic evaluation of their liquidity position and better understand the condition of their financial instruments portfolio. We can review financial institutions’ IT systems and operational structures as well as the policies and procedures that govern the asset and liability management system in order to adapt it to the current market conditions.

How improvement can be done

Develop and improve liquidity contingency plans under the crisis conditions

Analyse actual liquidity and evaluate liquidity risk Assess the relevance and efficiency of models used to analyse

assets and liabilities Design scenarios and stress tests to analyse the efficiency of

policies and models for liquidity contingency procedures under the crisis conditions

Develop policies and procedures for liquidity risk management Develop reporting systems within the asset and liability

management framework, including a system for monitoring liquidity risk

Analyse actual liquidity and the system of limits to make recommendations for necessary changes

Develop a methodology for evaluating the deposit base and the potential growth of accounts receivable due to realised contingencies

Test the current IT system architecture and evaluate its efficiency at maintaining procedures for asset and liability management. We can also help with selecting IT system providers

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Benefits to a client

Implementation of the standard industry practices used in Western markets

Consistent asset and liability management standards throughout the company

Increased transparency in identifying liquidity risk for the whole company.

Formalised policies and procedures Enhanced effectiveness and accuracy in evaluating liquidity

risk, communicating this to company management as well as risk testing and modelling

Automation of report preparation and the collection of analytical data for asset and liability management

Accurate segregation of duties and responsibilities within the liquidity management unit and control over liquidity monitoring performed by the company’s management

Pooling for effective liquidity management

Effective liquidity management requires an account structure that facilitates fast decisions and simplifies transfers between your accounts. When managing your liquidity, you may wish there were no borders or different currencies. We can make your wish come true.

Major companies often require a cash pool service. We offer different solutions, the most effective being a master account with corresponding sub accounts for subsidiaries and various departments. All funds are reflected in the master account. This solution minimises

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the need for credit facilities and provides better opportunities for placing excess liquidity in the money market. You can get interest benefits when accounts and pools in different countries and currencies are concentrated in Nordea.

The legal and regulatory requirements differ among countries and it is important for you to know which pooling structures are feasible. Depending on your company's group structure and business volumes, you may choose a liquidity management solution that reflects the current situation and your company's needs.

LIQUIDITY MANAGEMENT SYSTEM

Forecast - intraday, end of the day, contractual and predictive

Collateral management - consolidated position, pledged, available

Monitor — positions, accounts, alerts

Matching - expected vs. actual

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Sweeping/ Regulation – intraday, automatic/ manual

Flow control - scheduling, releasing, re-routing, channel management

Analyze – customer behavior, trend analysis, stress testing

Optimize - funding strategy, payment process

NECESSARY FEATURES OF LIQUIDITY CONTROL PROCESSES

Although future events cannot be fully anticipated it is possible to create a mechanism by which events can be identified and addressed as they emerge. It is recommended that banks embed within their liquidity control processes the following concepts:

Identify market changes: each bank should have a process, formal or otherwise, for spotting market changes that impact liquidity flows. Once identified such market level trends can be analyzed for its impact on the banks business.

Identify impact on banks liquidity: impacts on market and individual liquidity positions can next be projected. Environmental changes in say the securities market must be

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analysed for domino effects on the bank in other markets. A complete impact assessment can then be reviewed by the bank.

Reconfigure the banks strategic outlook: certain market developments will be of such significance that banks will reassess their set of component businesses. Decisions to exit or enter a business and re-deploy capital may well result. The nature of short and long term liquidity warehousing may also change due to these strategic decisions.

Establish tactical responses: as strategic responses to changing market conditions are developed, they must manifest themselves in procedural changes to day-to-day

liquidity management practices and the systems used to execute those practices. Ultimately all changes to financial flows impact interbank payment systems and member participants. Those systems and participants will have to alter payment operations and treasury funding processes as a result of changing strategic direction. Banks should strive to reduce the number of locations where used cash balances are available in their current account with RBI (possible through CFMS) to the absolute minimum given other practical constraints such as securities settlement and diversification of credit risks

Communicate changes and initiate training: once plans and processes are developed they must be adequately distributed across the organization. Formal training, process documentation and business continuity plans in support of payment processing liquidity management platforms are required. Payment operations an treasury staff must know how to (re)act when situations present themselves. As changes in the market place are identified all resulting situations that staff can anticipate

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should be identified. Corresponding actions and responsibilities should also be assigned.

Institutionalize quality assurance: banks should view their intra-day liquidity management practices in the larger contexts of best treasury management practices and industry recommendations for payments processing in general. At the most detailed level banks should also subject their payment practices to quality standards that relate to both internal and external service level agreements.

NECESSARY MECHANISMS FOR BANKS

To make the fullest use of the new payments mechanisms and in a sense be the market maker, banks would need to put in mechanisms to protect their business interests. These could be as follows:

Systematic treasury management: cross system position monitoring processes provide critical information to the treasury department including opening balances, paymentand receipts processed and payments and receipts pending.

Event matrix for contingencies: the event matrix identifies the array of anticipated events, corresponding action steps and responsibility for actions. Most (re) actions to gridlock

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Dynamic queue management: processes that consider current and projected liquidity of positions of individual payment systems can eliminate or reduce the impact of individual bank gridlock situations and the potential for systemic spillover effects.

Proactive treasury management: when it is not possible to solve gridlock situations through alternate routing techniques the treasury department can intervene in the process. For example temporary shortages in the banks current account with the RBI can be offset by inter-bank loans where willing counter-parties are available.

RBI’S LATEST VIEW ON LIQUIDITY MANAGEMENT

In its Mid-Term Review of the Annual Policy Statement for 2008-09, the Reserve Bank of India indicated that in the context of the uncertain and unsettled global situation and its indirect impact on our domestic economy and our financial markets, it would closely and continuously monitor the situation and respond swiftly and effectively to developments. In doing so, the Reserve Bank will employ both conventional and unconventional measures. Global financial conditions continue to remain uncertain and unsettled, and early signs of a global recession are becoming evident. These developments are being reflected in sharp declines in stock markets across the world and heightened volatility in currency movements. International money

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markets are yet to regain calm and confidence and return to normal functioning.

It was also indicated in the Mid-Term Review that the current challenge for the conduct of monetary policy is to strike an optimal balance between preserving financial stability, maintaining price stability and sustaining the growth momentum. Inflation, in terms of the wholesale price index (WPI), has been softening steadily since August 9, 2008 and has declined to 10.68 per cent for the week ended October 18, 2008. Globally, pressures from commodity prices, including crude, appear to be abating. The moderation in key global commodity prices, if sustained, would further reduce inflationary pressures. On the growth front, it is important to ensure that credit requirements for productive purposes are adequately met so as to support the growth momentum of the economy. Domestic financial markets have been functioning normally. Prudent regulatory surveillance and effective supervision have ensured that our financial sector has been and continues to be robust. However, the global financial turmoil has had knock-on effects on our financial markets; this has reinforced the importance of focusing on preserving financial stability, The Reserve Bank has reviewed the current and evolving macroeconomic situation and liquidity conditions in the global and domestic financial markets. Based on this review, it has decided to take the following further rmeasures:

(i) On October 20, 2008, the Reserve Bank announced a reduction in the repo rate under the Liquidity Adjustment Facility (LAF) by 100 basis points from 9.0 to 8.0 per cent. In view of the ebbing of upside inflation risks as also to address concerns relating to the moderation in the growth momentum, it has been decided to reduce the repo rate under the LAF by 50 basis points to 7.5 per cent with effect from November3,2008.

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(ii) The cash reserve ratio (CRR) of scheduled banks is reduced by 100 basis points from 6.5 per cent to 5.5 per cent of net demand and time liabilities (NDTL). This will be effected in two stages: by 50 basis points retrospectively with effect from the fortnight beginning October 25, and by a further 50 basis points prospectively with effect from the fortnight beginning November 8, 2008. This measure is expected to release around Rs.40,000 crore into the system.

(iii) On September 16, 2008, the Reserve Bank had announced, as a temporary and ad hoc measure, that scheduled banks could avail additional liquidity support under the LAF to the extent of up to one per cent of their NDTL and seek waiver of penal interest. It has now been decided to make this reduction permanent. Accordingly, the Statutory Liquidity Ratio (SLR) will stand reduced to 24 per cent of NDTL with effect from the fortnight beginning November 8, 2008.

(iv) In order to provide further comfort on liquidity and to impart flexibility in liquidity management to banks, it has been decided to introduce a special refinance facility under Section 17(3B) of the Reserve bank of India Act, 1934. Under this facility, all scheduled commercial banks (excluding RRBs) will be provided refinance from the Reserve Bank equivalent to up to 1.0 per cent of each bank's NDTL as on October 24, 2008 at the LAF repo rate up to a maximum period of 90 days. During this period, refinance can be flexibly drawn and repaid.

(v) On October 15, 2008 the Reserve Bank announced, purely as a temporary measure, that banks may avail of additional liquidity support exclusively for the purpose of meeting the liquidity requirements of mutual funds (MFs) to the extent of up to 0.5 per cent of their NDTL. A similar facility of liquidity support for non-banking financial companies (NBFCs) is also found to be necessary to enable them to manage their funding requirements. Accordingly, it has now been decided, on a purely temporary and ad hoc basis, subject to review, to extend this facility and allow banks to avail liquidity

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support under the LAF through relaxation in the maintenance of SLR to the extent of up to 1.5 per cent of their NDTL. This relaxation in SLR is to be used exclusively for the purpose of meeting the funding requirements of NBFCs and MFs. Banks can apportion the total accommodation allowed above between MFs and NBFCs flexibly as per their business needs.

(vi) As indicated in the Reserve Bank's press release of September 16, 2008, as on some previous occasions, the Reserve Bank will continue to sell foreign exchange (US dollar) through agent banks to augment supply in the domestic foreign exchange market or intervene directly to meet any demand-supply gaps. The Reserve Bank would either sell the foreign exchange directly or advise the bank concerned to buy it in the market. All the transactions by the Reserve Bank will be at the prevailing market rates and as per market practice. Entities with bulk forex requirements can approach the Reserve Bank through their banks for this purpose.

(vii) It has been decided, as a temporary measure, to permit Systemically Important Non-Deposit taking Non-Banking Financial Companies (NBFCs-ND-SI) to raise short- term foreign currency borrowings under the approval route, subject to their complying with the prudential norms on capital adequacy and exposure norms

(viii) Under the Market Stabilisation Scheme (MSS), Government Securities (treasury bills and dated securities) have been issued to sterilise the expansionary effects of forex inflows. In the context of forex outflows in the recent period, it has been decided to conduct buy-back of MSS dated securities so as to provide another avenue for injecting liquidity of a more durable nature into the system. This will be calibrated with the market borrowing programme of the Government of India. The securities proposed to be bought back and the timing and modalities of these operations are being notified

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separately.

The Reserve Bank will continue to closely monitor the developments in the global and domestic financial markets and will take swift and effective action as appropriate.

Liquidity Management in India: A Practitioner's View

Rakesh Mohan

Liquidity Management in India" is a subject that is not widely discussed but is the bread and butter of daily monetary management. Whereas I was not a monetary specialist prior to coming to the Reserve Bank, I have been able to gather some insights through on-the-job training. It is also an issue of current relevance and appeal.

Conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries. As India became convertible on the current account, and liberalised its capital account in a carefully sequenced manner since the balance of payment crisis of 1991, it too has been faced with similar problems. The evolving policy mix involved careful calibration that took into account diverse objectives of central

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banking, changes in the monetary policy framework and operating procedures, and widening of the set of instruments for liquidity management.

Before opening of the economy through the 1990s, both the current and capital accounts were controlled. However, despite trade restrictions the current account was in constant deficit, which had to be financed mostly by debt, both official aid flows and private debt. Portfolio flows were not permitted and foreign direct investment was negligible. The only largely "uncontrolled" flows were NRI deposits, which waxed and waned according to macro-economic conditions. The exchange rate was also controlled: it was linked to a basket of currencies and moved as a crawling peg. Consequently, monetary policy management, such as it was, did not pose serious problems, particularly since most interest rates were fixed administratively.

It is only after substantial opening of the economy, and deregulation of interest rates that price discovery of the rate of interest has become important. Consequently the Reserve Bank has had to experiment on a continuous basis. It has had to operate simultaneously on the external account in the foreign exchange market to contain volatility in the exchange rate, and in the domestic market to contain volatility in interest rates. Since both the exchange rate and interest rate are the key prices reflecting the cost of money, it is particularly important for the efficient functioning of the economy that they be market determined and be easily observed. Excessive fluctuation and volatility masks the underlying value and gives rise to confusing signals. The task of liquidity management then is to provide a framework for the facilitation of forex and money market transactions that result in price discovery sans excessive volatility.

Capital Flows in India

The far reaching economic reforms in India in the 1990s, witnessed a sharp increase in capital inflows as a result of capital account liberalisation in India and a gradual decrease in home bias in asset allocation in advanced economies. During 1990-91, it was clear

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that the country was heading for a balance of payment crisis caused by increased absorption due to deficit financed fiscal expansion of the 1980s and the trigger of oil price spike caused by the Gulf War. As foreign exchange reserves dwindled to less than a month’s import financing requirements in 1991, global capital taps got switched off and the country faced a real possibility of a first ever sovereign default. Crisis managers got active and averted the default, leaving the country still with a default-free history. The survival stimuli it kindled, unleashed massive economic reforms. The reform story has been told several times in many different fora and I do not intend to repeat it here.

Foreign investment flows, mainly in the form of foreign direct investments, averaged US$118 million during 1990-91 and 1991-92. A significant change in our capital account took place when portfolio investments by foreign institutional investors were permitted in 1992. With the exception of 1998-99 when, in the aftermath of contagion from East Asian financial crisis, portfolio flows turned negative, total foreign investment in the form of direct and portfolio investment was US$ 4-8 billion a year till 2002-03. Excluding 1998-99, it has averaged nearly US$ 5.8 billion over a 9-year period starting 1993-94. There was another quantum leap in the following two years – 2003-04 and 2004-05 with direct investment averaging US$ 5.1 billion and portfolio investment averaging US$ 10.1 billion, taking total foreign investment exceeding US$ 15 billion. As it happened, this increase in capital flows coincided with a slowdown in the economy, particularly the industrial economy after 1997-98, and instead of current account deficits we had current account surpluses. Consequently, even ignoring the non-resident deposit flows, equity investment flows in themselves posed a considerable challenge for monetary management.

While the year to year foreign investment flows provide some idea of the magnitude of the capital flows that may be required to be sterilised, the month-to-month or intra-month variations in these flows provide a better idea of the volatility of these flows with which central bank liquidity management has to cope and these variations have been sizeable. They have been dominated by portfolio flows. While these

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flows appeared to be mean reverting till October 2002, there appears to have been a strong trend with wider oscillations subsequently. This means that the monetary authorities now have to cope with larger and more volatile capital flows than it had been faced with in about a decade from the onset of reforms.

Faced with these large capital flows, there has been a steep accretion to foreign exchange reserves starting October 2000. Over US$ 100 billion have been added in foreign exchange reserves since then, taking them from US$ 34.9 billion to US$ 143.6 billion in October 2005. IMD redemptions saw the reserves temporarily dropping to US$ 135 billion at end-December 2005 but the reserves are back at US$ 146.2 billion by March 17, 2006 (Chart 1). The reserve accretion of this large magnitude has been largely the result of massive capital flows. The capital flows are adding to absorption directly as well as indirectly through increased domestic credit growth and have resulted in a steep rise in trade deficit and, till at least recently, substantial excess liquidity in the economy. The problem of scarcity of 1991 is now seen as a problem of plenty by many.

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In these circumstances, the problem for monetary management was two-fold. First, it had to distinguish implicitly between durable flows and transient flows. If capital flows are deemed to be durable and indefinite, questions arise regarding foreign exchange management. If the flows are deemed to be semi-durable, essentially reflecting the business cycle, the task of monetary and liquidity management is to smoothen out their impact on the domestic economy, finding means to absorb liquidity in times of surplus and to inject it in times of deficit. Second, in the short term, daily, weekly or monthly volatility in flows needs to be smoothened to minimise the effect on domestic overnight interest rates. In practice, ex-ante, it is difficult to distinguish what is durable, what is semi-durable and what is transient. Hence policy and practice effectively operates in an environment of uncertainty and a variety of instruments have to be used to manage liquidity in this fluid scenario.

Liquidity Management through Indirect Instruments: Early Trends

Before the advent of repos, market operations by the RBI almost invariably focused on open market operations through outright transactions in government securities. The scope of open market operations in the earlier period was limited as yields were repressed by an administered interest rate regime, including auctions of T-bills on tap at fixed coupon of 4.6 per cent. The move towards a market determined system of interest rates began by development of the secondary market by increasing coupons and decreasing maturity of government debt1. The yields were made substantially market determined by introduction of auctions since the mid-1980s2. The Reserve Bank introduced reverse repos for absorption from December 19923. With the objective of improving short-term management of liquidity in the system and to smoothen out interest rates in the call/notice money market, the Reserve Bank began absorbing excess

1

2

3

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liquidity through auctions of reverse repos (then called repos). The development of repos into a full fledged monetary instrument in the form of LAF has been a fascinating case study of what it takes to undertake changes in operating framework. The chronology of these developments is provided in Box-I. Till 2003-04, market operations were primarily conducted in the form of outright sales and purchases of government securities (Chart-2). Since then, LAF volumes have increased considerable (Chart-3). The important contribution of LAF has been in keeping overnight interest rates by and large range bound. With the activation of bank rate as a policy instrument, reverse repos helped in creating an informal corridor in the money market, with the reverse repo rate as floor and the Bank Rate as the ceiling. The use of these two instruments enabled RBI to keep the call rate by and large within this informal corridor.

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Although repo auctions were conducted at variable rates when LAF was introduced, with a view to providing quick interest rate signals, RBI did have the additional option to switch over to fixed rate repos on overnight basis, in order to meet unexpected domestic or external developments. LAF was introduced on the basis of uniform price auctions, but the auction system was switched to multiple price auctions from May 5, 2001 (Box - I).

Box-I: Liquidity Adjustment Facility

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The choice of operating framework and operating procedures in any economy is always a difficult one and depends on the stage of macro-economic and financial sector development and is somewhat of an evolutionary process. As part of the financial sector reforms launched in mid-1991, India began to move away from direct instruments of monetary control to indirect ones. The transition of this kind involves considerable efforts to develop markets, institutions and practices. In order to facilitate such transition, India developed a Liquidity Adjustment Facility (LAF) in phases considering country-specific features of the Indian financial system. LAF is based on repo / reverse repo operations by the central bank.

In 1998 the Committee on Banking Sector Reforms (Narasimham Committee II) recommended the introduction of a Liquidity Adjustment Facility (LAF) under which the Reserve Bank would conduct auctions periodically, if not necessarily daily. The Reserve Bank could reset its Repo and Reverse Repo rates which would in a sense provide a reasonable corridor for the call money market. In pursuance of these recommendations, a major change in the operating procedure became possible in April 1999 through the introduction of an Interim Liquidity Adjustment Facility (ILAF) under which repos and reverse repos were formalised. With the introduction of ILAF, the general refinance facility was withdrawn and replaced by a collateralised lending facility (CLF) up to 0.25 per cent of the fortnightly average outstanding of aggregate deposits in 1997-98 for two weeks at the Bank Rate. Additional collateralised lending facility (ACLF) for an equivalent amount of CLF was made available at the Bank Rate plus 2 per cent. CLF and ACLF availed for periods beyond two weeks were subjected to a penal rate of 2 per cent for an additional two week period. Export Credit refinance for scheduled commercial banks was retained and continued to be provided at the bank rate. Liquidity support to PDs against collateral of government securities at the bank rate was also provided for. ILAF was expected to promote stability of money market and ensure that the interest rates move within a reasonable range.

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The transition from ILAF to a full-fledged LAF began in June 2000 and was undertaken in three stages. In the first stage, beginning June 5, 2000, LAF was formally introduced and the Additional CLF and level II support to PDs was replaced by variable rate repo auctions with same day settlement. In the second stage, beginning May 2001 CLF and level I liquidity support for banks and PDs was also replaced by variable rate repo auctions. Some minimum liquidity support to PDs was continued but at interest rate linked to variable rate in the daily repos auctions as determined by RBI from time to time. In April 2003, the multiplicity of rates at which liquidity was being absorbed/injected under back-stop facility was rationalised and the back-stop interest rate was fixed at the reverse repo cut-off rate at the regular LAF auctions on that day. In case of no reverse repo in the LAF auctions, back-stop rate was fixed at 2.0 percentage point above the repo cut-off rate. It was also announced that on days when no repo/reverse repo bids are received/accepted, back-stop rate would be decided by the Reserve Bank on an ad-hoc basis. A revised LAF scheme was operationalised effective March 29, 2004 under which the reverse repo rate was reduced to 6.0 per cent and aligned with bank rate. Normal facility and backstop facility was merged into a single facility and made available at a single rate. The third stage of full-fledged LAF had begun with the full computerisation of Public Debt Office (PDO) and introduction of RTGS marked a big step forward in this phase. Repo operations today are mainly through electronic transfers. Fixed rate auctions have been reintroduced since April 2004. The possibility of operating LAF at different times of the same day is now close to getting materialised. In that sense we have very nearly completed the transition to operating a full-fledged LAF.

With the introduction of Second LAF (SLAF) from November 28, 2005 market participants now have a second window to fine-tune the management of liquidity. In past, LAF operations were conducted in the forenoon between 9.30 a.m. and 10.30 a.m. SLAF is conducted by receiving bids between 3.00 p.m. and 3.45 p.m. The salient features of SLAF are the same as those of LAF and the settlement for both is conducted separately and on gross basis.

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The introduction of LAF has been a process and the Indian experience shows that phased rather than a big bang approach is required for reforms in the financial sector and in monetary management.

The introduction of LAF had several advantages.

First and foremost, it helped the transition from direct instruments of monetary control to indirect and, in the process, certain dead weight loss for the system was saved.

Second, it has provided monetary authorities with greater flexibility in determining both the quantum of adjustment as well as the rates by responding to the needs of the system on a daily basis.

Third, it enabled the Reserve Bank to modulate the supply of funds on a daily basis to meet day-to-day liquidity mismatches.

Fourth, it enabled the central bank to affect demand for funds through policy rate changes.

Fifth and most important, it helped stabilise short-term money market rates.

The call rate has been largely within a corridor set by the repo and reverse repo rates, imparting greater stability in the financial markets. As has been mentioned, the emergence of corridor was gradual. The transition is not a menu choice as is sometimes viewed in text books.

LAF has now emerged as the principal operating instrument of monetary policy. Although there is no formal targeting of overnight interest rates, the LAF is designed to nudge overnight interest rates

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within a specified corridor, the difference between the fixed repo and reverse repo rates, currently 100 basic points. The LAF has enabled the Reserve Bank to de-emphasise targeting of bank reserves and focus increasingly on interest rates. This has helped in reducing the CRR without loss of monetary control.

Liquidity Management in the More Recent Period

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Let me now focus on our experience in liquidity management in recent years. After the introduction of the second stage of LAF in May 2001, liquidity has generally been in surplus mode with the increase in levels of capital flows and in the presence of a current account surplus until 2003-04. With the continuing accretion to foreign exchange reserves, there was corresponding injection of liquidity that had to be strerilised. At the same time, the reverse repo policy interest rate was reduced in successive steps from 6 per cent in March 2002 to 4.5 per cent by August 2003 before raising it to 5.50 per cent by January 2006 in four increases of 25 basis points each. Thus, the aim of monetary policy was to keep overnight call money market rates in the system within the informal interest rate corridor.

On the whole, LAF has had a pronounced favourable impact of lowering volatility of short-term money market rates. Monthly average call rates, which were volatile in a 5-35 per cent band during 1990-98, have clearly stabilised subsequently and have generally ranged between 5-10 percent (Chart 4). Call rates have become largely bounded by the informal interest rate corridor after the introduction of LAF (Chart 5). The corridor between repo and reverse repo rates which was set at 200 basis points initially and was widened to 250 basis points in August 2003 was lowered to 150 basis points in March 2004, to 125 basis points in October 2004 and further to 100 basis points in April 2005. The call rates have remained anchored around the lower corridor since June 2002, except for a brief period during February-April 2003 and between October 2004 and January 2005. Again since October 2005, the system appears to have clearly moved from enduring surplus to marginal deficits.

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Monetary management since mid-2002 has clearly focused on managing surplus liquidity. This was accomplished by the simultaneous operation of the LAF and open market operations.

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Given that RBI had a finite stock of government securities its ability to mop up large capital inflows indefinitely was therefore limited, and LAF operations began to bear the burden of stabilisation disproportionately. Moreover, the LAF is essentially designed to take care of fictional liquidity on a day-to-day basis, hence its function was itself beginning to get distorted by such a sterilisation.

.

Lessons from the Indian Experience & Coping Ahead

What has been the lesson from the Indian experience of coping with liquidity management under large and volatile capital flows?

First, by putting reforms on a more stable footing by adopting gradualism but avoiding reversals, it has been able to sustain capital inflows on a more stable basis with lower volatility than has been seen in some other emerging markets. This has helped central banks in smoothening out interest rates under cyclical transition.

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Second, in cases where money and debt markets have depth, development of open market operations through repo operations is particularly important for building up microeconomic capacities for macroeconomic objective of liquidity management. In India, the emergence of LAF was a single biggest factor which helped to manage liquidity amidst large and volatile capital flows and to keep short-term interest rates stable in this environment. It widened the range of instruments for monetary policy and enabled the Reserve Bank to operate on shorter range of interest rates. Restricting the maturities of interest rates at which central bank operates to a smaller range at the short-end has reinforced market functioning.

Third, in the face of constraints on sterilisation arising from paucity of instruments, the monetary authorities in India adopted a careful strategy which preserved the strength of the central bank balance sheet and the credibility of the central bank, while causing minimal frictions in the debt markets. MSS was not contemplated of initially even while capital flows had distinctly increased since 1993-94. However, in face of large surplus liquidity since 2000, MSS was evolved as a very useful instrument of monetary policy to sustain open market operations. MSS has marginal costs, but it has helped the monetary authorities manage business and liquidity cycles through the surpluses and the deficits. With MSS, the monetary authorities now have the option of assigning LAF for day-to-day liquidity management, using MSS for addressing semi-durable liquidity mismatches, while using outright sales/purchases of dated securities for truly long-term liquidity surpluses or deficits. The MSS experience tells us that operating framework and procedures undergo changes and one need to keep innovating to calibrate market operations to the evolving liquidity conditions.

Fourth, by focusing on the microstructure of the markets and by facilitating development of a wider range of instruments such as Collateralised Borrowing and Lending Obligation (CBLO)4, market repo, interest rate swaps, Certificates of Deposit (CDs) and Commercial Papers (CPs), in a manner that avoided market 4

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segmentation while meeting demand for various products, liquidity management could be placed on a much firmer footing. Market and central bank practices evolved to institutional developments. However, the payment and settlement system proved to be the most difficult area, but one which delivered the enabling environment for micro and macro developments supportive of the liquidity management procedures now in place. The focus on micro-aspects reinforced the central bank's ability to signal and transmit policy changes.

Fifth, with efforts to build up indirect instruments for liquidity management, the transmission of monetary policy has improved. The link between overnight interest rates and yields on T-bills and liquid dated securities has become far stronger. While the lending rates and even more so deposit rates have been taking considerable time to adjust, the strength of the transmission has been in evidence in recent periods. It is important to note that in a situation of large surplus liquidity, the transmission is understandably weaker. However, in the more recent period as considerable amount of excess liquidity was mopped up by the central bank, the rate signal efficacy has gone up substantially.

Sixth, monetary policy setting through signalling improves, as the central bank's liquidity management is able to establish its control over short-term interest rate by reducing volatility in these rates. By removing working balance constraints for the banks, it can influence the term structure of interest rates as reflected in money market rates of various maturities and the sovereign yield curve.

Lastly, while temporary mismatches in liquidity conditions do pose a problem for maintaining immediate goals of monetary operations, the overall objective of liquidity management needs to accorded primacy. In India, in spite of difficulties posed by sudden transitions in liquidity conditions, macroeconomic success of overall policies are reflected in delivering low inflation, which at 4.7 per cent, has averaged below 5.0 per cent over last five years in terms of the headline rate. Consumer price inflation has averaged still lower at

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around 4.0 per cent on a point-to-point basis and 3.9 per cent on an average basis.

In spite of the relative success in liquidity management in India, several challenges remain ahead.

First, notwithstanding the large size of the debt markets, absence of a vibrant term market, the illiquidity of a large set of securities and limitations of corporate debt market continue to come in way of further contemplated changes.

Second, while the Reserve Bank now enables market participants to meet their marginal liquidity demand twice a day on each working day, there is a moral hazard that passive operations by central bank in the market may be resulting in some market players not doing enough for their own liquidity management.

Third, as the system moves to maintenance of SLR securities at statutory minimum levels, liquidity provision would become more difficult unless the instrument set is widened to facilitate market players to even out their liquidity mismatches.

Fourth, as RBI withdraws from the primary market in accordance with the FRBM Act, 2003, there is an urgent need to bridge the institutional gap with minimal necessary changes so that market operations retain their efficiency, both from the view point of central bank and the market participants.

Finally, further improvements in liquidity management would substantially depend on our abilities to improve forecasting of liquidity in the system. The short span within which liquidity conditions have been changing by a large amount has been the biggest constraint in targeting short-term interest rates. More effort for understanding the fiscal position and the government cash balances, as also the timing of foreign capital flows are of paramount importance in this context.

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Liquidity Management in Banks becoming moreComplex

With the splurge in the credit off-take in the recent past, banks have had to increase their reliance on bulk funding sources. At the same time many of them have also been paring their excess Statutory Liquidity Ratio (SLR) portfolio to fund the credit growth. While this strategy helped them till the recent past, it is unlikely to help them in future given the fact that most of the bank’s SLR portfolio are just about adequate to meet the statutory requirements, hence leading to a scramble to garner bulk deposits.

Though it is a known phenomenon that banks borrow short-term and lend long-term, the asset liability mismatch has increased in the last 1-2 years with the increasing thrust on expanding their asset base. The mismatch is accentuated with the increasing preference of the

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corporate and high net worth depositors to invest in banks only for short-terms or through more tax efficient fixed maturity plans (debt schemes) floated by various mutual funds. Consequently banks in the recent past have had to increase reliance on the short-term sources of deposits. Though the banks have begun marketing the long-dated fixed deposits to retail investors by enticing the depositors with tax benefits and higher interest rates, ICRA does not expect a significant shift in the asset liability mismatch (ALM) profile of the banks at least over the short term. In addition, Reserve Bank of India’s (RBI) immediate objective to curb the rising inflation numbers is likely to keep a tight liquidity profile over the short term. As a result, banks will have to find alternate sources of funds or may have to curtail their credit growth rates till such times the liquidity profile improves.

ICRA expects the liquidity pressures in the banking system to continue for some more time. It is important to note that while banks are taking steps to improve the low cost deposit base, it is a time consuming exercise. Consequently, the banks will have to find alternate sources of funds or may have to curtail their credit growth rates till such times the liquidity profile improves. We also find that unlike in the past, wherein no bank considered slowing business volumes, some of them have in fact in the current scenario, started deliberating on the necessity of curbing business growth for the next 3-4 months. However whether they actually take that step remains to be seen.

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CONCLUSION

Liquidity risks are endemic to banking given the maturity transformation they undertake. First line of defence should be appropriate liquidity policy on asset and liability side, supported by adequate capital and firm supervision. Despite these, solvent banks can face liquidity difficulties at times of stress necessitating liquidity support.

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REFERENCES

Monetary Policy and Operations in Countries with Surplus Liquidity, Economic and Political Weekly.

Obstfeld.M, Shambaugh, J.C. and A.M. Taylor "The Trilemma in History: Tradeoffs Among Exchange Rates, Monetary Policies and Capital Mobility.”

“The Implementation of Monetary Policy in Industrial Countries”, BIS Economic Papers No. 47, Bank of International Settlements.

"Central Bank Liquidity Management: Theory and Practice", April, European Central Bank.

Alexander, W.E., T.J.T. Balino and C. Enoch (1995), “The Adoption of Indirect Instruments of Monetary Policy”, IMF Occasional Paper, No. 126, Washington, D.C.

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