Liquidity Management within Banks

Liquidity is key to the operations of banks and other financial institutions and managing liquidity risk is a very important function that is often overlooked. At times, the need for liquidity can override profitability or the choice of products that a bank handles. The liquidity resources of a bank are important factors in determining the credit-worthiness of the institution itself as well as the rating accorded to it by agencies like Moody's, Standard & Poor's or Fitch Ratings. At the end of the day, liquidity and solvency are inter-related. Without adequate liquidity, banks may not be able to meet their obligations, even if they have a positive balance sheet.

Effective liquidity management is an intrinsic part of effective bank asset and liability management (ALM). In fact, it is almost impossible to properly manage the latter without effectively managing the former. Liquidity risk is, at the end of the day, one of the key risks that banks have to consider as part of their operations. Liquidity risk comes into play in a broad range of operational areas and can be affected by legal and tax events or regulatory requirements, to name just two examples. At its very core, liquidity risk is the risk that a bank or other financial institutions may be unable to meet its obligations as they fall due. This inability to meet obligations could be caused by a variety of factors including a bank's ability to liquidate assets or access short-term funding through discount windows or interbank facilities. Problems can also be caused by problems of liquidity in the broader market at times of crisis. At times of dropping interest rates or slowing economic growth, liquidity risk generally rises and drops as economic recovery kicks in and interest rates start to go up, to mention but one overly simplified example. (Lehman Brothers is an example)

At this article we will consider the definition and measure of liquidity, including the principles on liquidity management used by the Basel Committee on Banking Supervision (BCBS), the liquidity coverage ratio and the net stable funding ratio. Then, we will look at how banks and financial institutions determine their funding needs and this is followed by a look at how stress tests are implemented and the role they play in managing liquidity.

It is key for banking professionals to understand how individual banks and other financial institutions manage their liquidity. It is also key for them to have a solid grasp of the factors that go into determining what an adequate level of liquidity is, and the tools that banks and regulators use to ensure that banks have enough liquidity on hand at all times. These tools have become increasingly sophisticated over the decades, as both practitioners and regulators learn painful lessons from times of crisis, bank runs and failures that are, if not frequent, far too common.

Definition and Measures of Liquidity

The Basel Committee on Banking Supervision (BCBS) says liquidity is ‘the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses’. Banks make money by taking in short-term deposits by their clients and lending those funds out as longer-term loans. This discrepancy opens banks up to liquidity risk.

Regulators have not been blind to this risk for many decades; it was the bank runs of the Great Depression that exposed the dangers to the public of this discrepancy in the tenor of deposits and loans, not to mention other obligations and assets that may populate the balance sheets of banks and other financial institutions. There is virtually no transaction or commitment that a bank might undertake that does not impact its liquidity position in some way. And, if the liquidity position of one bank or one institution is affected, so is the market as a whole. A shortfall of liquidity in one bank—imagine going to your bank and not having access to your money or a bank not having the cash to make interest payments—can have a massive impact on the financial system as a whole.

One lesson from the global financial crisis is that banks and financial institutions may overlook the basic principles of liquidity risk management during good times, which leaves them exposed during times of crisis. Since 2008, regulators around the world have tightened up the frameworks under which they consider the adequacy of the liquidity position of individual institutions.

BCBS Principles for Managing Liquidity Risk

Much of the work of the BCBS, particularly in the aftermath of the Global Financial Crisis (GFC), has revolved around how financial institutions should manage their liquidity. Basel III, the latest series of agreements that guide most bank regulation around the world, includes a series of principles for the management and supervision of liquidity risk (see down mentioned table). Basel III liquidity rules require banks to hold high quality liquid assets (HQLA) in their balance sheets.

Basel Committee on Banking Supervision reforms – Basel III Table.

Strengthens micro prudential regulation and supervision, and adds a macroprudential overlay that includes capital buffers.

The Basel III rules on capital management and liquidity management are being phased in over several years to 2019. While the aim of the rules is to make banks around the world stronger, at a very practical level abiding by the rules is a complex process. The BCBS reforms include new rules for liquidity management. These rules are based on more stringent supervisory monitoring, the application of the ‘Principles for Sound Liquidity Risk Management and Supervision’ that the BCBS put forward in 2008 as well as greater monitoring of the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

The BCBS provides 15 principles for the management and supervision of liquidity risk. The aim of these principles is to ensure that banks and other financial institutions always have enough liquidity at hand to cover their operating needs. The latest set of principles was put forward in September 2008, replacing the earlier ‘Sound Practices for Managing Liquidity in Banking Organizations’, that was put out in 2000.

The first and most fundamental of the BCBS principles on the management of liquidity risk makes it clear that banks are responsible for their liquidity and must manage any associated risks. This requires the creation of a strong internal management framework that takes into account possible losses as well as both secured and unsecured sources of funds. Regulators, for their part, are entrusted in ensuring that banks abide by the principles and maintain strong liquidity positions at all times.

Governance is a key consideration. Banks should be clear as to what their tolerance levels are and the liquidity needs of their particular business strategy. It is up to management to develop a strategy for liquidity management that matches the bank's strategy. What's more, both the tolerance levels and the management of liquidity should be constantly reviewed. Banks should also take into account the cost of liquidity when formulating a strategy—and remember that costs can change along with macro-economic environments.

Just as important is the development of a system to monitor and control risks associated with liquidity, or the lack of it. Cash flow projections are key, as are considerations of items such as forex values, changing interest rates and maturities or time horizons, all of which can have a sudden impact on liquidity. The general idea behind the BCBS principles is that there are no surprises and banks or other financial institutions always anticipate risk events—in other words, that they are ahead of, at least, the predictable developments in their operations.

This ability to predict, which is part of effective management of liquidity positions, should be visible in the short, medium and long terms. Banks should be just as prepared to manage intraday liquidity positions as they are to meet monthly or annual obligations, both under normal conditions and at times of . The BCBS principles underscore this requirement (Principle 8) as well as the requirement that collateral positions should be carefully managed and monitored, lest they become less valuable than the liability to which they are attached.

Three other considerations are also important. One is a requirement for banks and regulators to carry out regular tests, both at the institutional level and across the market. The need for bailouts in the United States during the Global Financial Crisis (GFC) underscored the importance of such tests to avoid market meltdowns. A second is the need for banks and other financial institutions to have contingency funding plans that they can resort to in times of, particularly in modern times when regulators are less willing to step in to save institutions and the sums involved are increasingly large. A third is, ideally, to make the tests redundant and the need to implement contingency plans nothing more than a theoretical exercise—banks should have a cushion of ‘unencumbered, high quality liquid assets to be held as insurance against a range of liquidity stress scenarios’.

The BCBS principles deal with two other areas that are important for banks, financial institutions and the supervisory authorities that keep an eye on them. The first is regular public disclosures that allow for informed judgements about the soundness of a liquidity management approach of a particular institution. The second is the role of supervisors, who are expected to ensure sound management of liquidity across institutions through monitoring, testing, effective interventions before a risk event and, just as importantly, through regular communication with other regulators in different geographies.

Liquidity Coverage Ratio (LCR)

The liquidity coverage ratio (LCR) measures the number of high-quality liquid assets that banks have on hand to withstand a 30-day stressed funding scenario specified by supervisors. The BCBS revised the ratio in early 2013, issuing a new way to calculate it in January of that year. The LCR is a key component of the reforms ushered in with Basel III. In the period from 2015 to 2019, the minimum LCR requirement for banks should increase by 10% per year to 100%.

The aim of the LCR is to strengthen capital and liquidity regulations and shore up not only individual banks but also entire banking systems, the weaknesses of which have become clear in the years since 2008. The LCR was first published in 2010, along with a process to review the standard and a commitment to deal with unintended consequences quickly. The 2013 revision incorporated changes to the definition of high-quality liquid assets (HQLA) and net cash outflows as well as a revised timetable for implementation.

The aim of the LCR is to make banks more resilient in the short term with access to enough liquidity—or assets that can be quickly converted into liquidity—to cover all its needs for 30 days.

There are two parts to the LCR. The first is the value of the stock of a bank's HQLA and the other is the total net cash outflows. The LCR is expressed as:

When it is fully implemented in 2019, banks and other financial institutions should have enough HQLA in hand to cover all their net cash outflows for 30 days. As of 2015, the LCR requirement under the BCBS standards was 60%, meaning that banks needed to have enough HQLA to cover 60% of their cash outflows for the period. The timetable from 2015 was as follows: in 2016, the ratio to rise to 70%, then 80% in 2017, 90% in 2018 and, finally, 100% in 2019.

There are two kinds of HQLA assets considered under the LCR.

Level 1 assets include cash, central bank reserves and some marketable securities backed by sovereigns and central banks. These assets are both high quality and very liquid and there is no limit on how many of these assets banks can hold to meet the requirements of the ratio.

Level 2 assets are of lower quality. They are further subdivided into Level 2A and Level 2B. Level 2A assets include some government securities, covered bonds and corporate securities. Level 2B assets include lower rated corporate bonds, residential mortgage-backed securities and some equities that meet a few conditions. When counted in aggregate, Level 2 assets may not account for more than 40% of the HQLA that a bank counts towards the LCR. Level 2B assets may not account for more than 15% of the HQLA.

In turn, the total net outflows are defined as the total expected cash outflows minus the inflows under a specified stress scenario for 30 calendar days. The BCBS says the outflows should be calculated by multiplying the outstanding balances of various liabilities and off-balance-sheet commitments by the rates at which they are expected to be drawn down. Inflows are calculated by a similar but opposite process that counts inflows of cash and the rate at which they are expected. Cash inflows are subject to a cap of 75% of outflows, which ensures a minimum level of HQLA at all times.

Net Stable Funding Ratio

As part of its liquidity-focused reforms to develop a more resilient banking sector, the BCBS has also developed the Net Stable Funding Ratio (NSFR), which requires banks to ‘maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities’. The NSFR is a longer-term structural ratio designed to address liquidity mismatches. It covers the entire balance sheet of a bank and provides incentives for banks to use stable sources of funding. The general idea is to limit risks associated with disruptions or changes to the regular sources of funding that a bank or other financial institution might have.

The mismatch that the BCBS sought to address with the NSFR is the lack of incentive for the private sector to limit too large a reliance on sources of funding that might be unstable, particularly during times of economic prosperity. Institutions that grow quickly during good times may not be prepared for the shocks of a sudden solvency crisis; and the interconnectedness of the financial system, and financial systems around the world, act as an amplifier to this risk. This was visible during 2007, when many banks easily met capital requirements in place at the time but were not able to properly manage their liquidity. Before the crisis, funding was both readily available and cheap but the conditions turned on a dime and the banking system was stressed beyond endurance. The result was institutional failures such as those of Bear Sterns or Lehman Brothers.

The NSFR is a measure of the amount of available ‘stable’ funding relative to the amount of required stable funding, and this ratio should be at least 100% on an on-going basis. The ratio is defined as:

The difficulty in using this ratio, one that national regulators have to deal with, is determining what is a stable source of funding. This determination is made by considering source of funding through two parameters. The first is the ‘funding tenor’ and, for the purposes of the NSFR, the longer-term liabilities are generally considered more stable than short-term ones. The second is the ‘funding type and counterparty’ and operates under the assumption that deposits from retail customers and funding by small business customers are more stable than wholesale funding of the same maturity.

To determine how much stable funding banks require, the BCBS puts forward a number of criteria including stable funding for some proportion of lending to the real economy, the behavior of banks and how they roll over maturing loans to preserve customers, the asset tenor that requires a smaller proportion of stable funding for short-dated assets, and the quality of assets and the value of liquidity with HQLA requiring less stable funding.

What is available stable funding (ASF)? The approach to determine what bank assets qualify as ASF is somewhat subjective and requires that banks assign a capital and liabilities to a particular category with a specific carrying value that is used to determine ASF. The amount assigned to each category is multiplied by an ASF factor and the total ASF is the sum of those amounts. (see the Summary of Liability Categories and associated ASF Factors table)

In turn, the amount of required stable funding (RSF) is measured along similar lines but the considerations are slightly different. The aim of determining RSF is to arrive at a proximate figure of the amount of a particular asset that would have to be funded either because it is rolled over or because it could not be monetized. Encumbered assets, secured financing transaction and other assets are given different RSF factors (see the Summary of Asset Categories and Associated RSF Factors table)

A final consideration is off-balance-sheet exposure that requires little or no direct or immediate funding but can be a drain to long-term liquidity. The NSFR assigns an RSF factor to these activities that is either 5% or left up to national supervisors to determine.

Determining Funding Needs

It is difficult to overestimate the importance of appropriately determining the funding needs that a bank or other financial institution might have. Banks are expected to be well funded, that is, to have enough funds at hand to cover their immediate liabilities. Every bank deposit is a liability as well as a trust. Clients trust that their money is where they put it and that they can access it at all times.

The Asset and Liability Management Committee (ALCO) is a risk management committee made up of senior management executives. Its primary goal is to evaluate, monitor and approve the various practices of the bank with a view to the risk they pose of creating imbalances in the bank's capital structure. In other words, the ALCO is key to ensuring that banks and other financial institutions are well funded. They do this by setting limits on arbitrage borrowing in short-term markets and ensuring an appropriate level of long-term instruments. They look at liquidity risk, interest rate risk, operational risk and the possibility of external events that could affect future funding needs and the strategic allocations in the bank's balance sheet.

The ALCO is an important piece of the machine that banks use to determine funding needs, but it is not the only one. Financial institutions also rely on a series of other tools, some of which are handed to them by regulators and others by common sense, established practice or the standards set by the BCBS. Among these tools that help ensure banks better determine their funding needs are reserve requirement ratios, analysis of loan and deposit trends, careful consideration of the liquidity gap and liquidity planning.

Reserve Requirement Ratios

The RRR is the portion of depositors' balances that banks have to keep on hand as cash or cash equivalents, basically capital in reserve. Banks may hold excess reserves but the RRR determines the minimum amount that they should hold. These reserves are included in a bank's balance sheet but they are not used to fund loans. A very simple equation to describe how the ratio impacts a bank's balance sheet is:

In this case, the ‘R’ refers to the RRR and the ‘E’ to the excess reserve ratio of the bank in question. This formula is useful in determining the total deposits that a bank has and can also be used to determine the portion of those deposits that it can realistically lend out. National regulators set the ratio to both ensure the strength of banks and to meet national monetary goals. As we discussed above, the RRR is a useful and relatively effective tool to add or take away liquidity from the market.

Not all countries use RRR. Middle East Central Banks, for example, follows the BCBS principles and relies instead on the capital and liquidity adequacy principles based on the LCR and the NSFR, among others. Other countries like Canada, Sweden, Australia and New Zealand have also abolished the traditional RRR. Rather, banks are increasingly relying on the risk-based capital requirements that the BCBS puts forward. The LCR is not unlike the traditional RRR, although it takes into consideration the quality of assets that banks hold.

Middle East Central Banks encourage banks to keep higher levels of reserves than those required by the BCBS standards, even though most banks in the Special Administrative Region typically maintain capital adequacy ratios already well above those required by the Basel committee.

Loan and Deposit

But how do banks determine their funding needs on an ongoing basis? Modern financial institutions are complex conglomerates with dozens of business lines, hundreds or thousands of branches, multiple subsidiaries and enough operational departments to make any observer dizzy. Managing this complexity can be a Herculean task. A key function is to analyze loan and deposit trends and use this analysis as part of a liquidity management strategy that shifts along with market conditions.

Banks and banking executives, economists, analysts and regulators pay close attention to loan and deposit trends and the loan to deposit ratio both in individual institutions and the financial system as a whole.

Take, for example, the month of June 2014 in Egypt (not for any particular reason). That month, according to the CBE's monetary statistics, loans grew 1.6% month-on-month while deposits grew just 0.9% month-on-month. The impact of this is counterintuitive. In effect, the assets of the banks and financial institutions in the system (the loans) rose by almost twice as much as the liabilities (the deposits). That month, the loan to deposit ratio across the whole system rose to 73.6%, up from 73.1% a month earlier.

This change was happening just as regulators put more emphasis on banks having enough sources of stable funding to support both their growth and the amount of liquidity. The upshot was the likelihood of higher funding costs for banks.

The Central Bank of Egypt (CBE) keeps careful tabs on these trends and adjusts the allowable loan to deposit ratio accordingly. Since 2013, the CBE expects banks to have enough stable sources of funding to match the maturity of both loans and deposits. The move followed a spike in loans issued across Egypt and the possibility of banks stretching themselves too thin. The fear was the banks were supporting their lending activities through short-term funding and were not fully prepared for a squeeze in the event of a bank run.

The lesson for banks is relatively simple, but not always easy to manage: they should ensure enough funding is in place to sustain growth. A traditionally conservative regulator, the CBE was working to ensure banks in Egypt did not end up with a negative liquidity gap that could pose a risk to their operations, threaten client funds or jeopardize the system as a whole.

Liquidity Gap

A liquidity gap is the difference between the assets and liabilities that a bank—or any firm, really—has. This gap is caused by the different properties that assets and liabilities might have. It can be positive or negative, depending on the balance sheet of a particular institution. The aim of effective liquidity planning is to ensure a positive gap at all times. The liquidity gap is, by its very nature, very volatile. It changes throughout every operating day as deposits and withdrawals are made or obligations met. The liquidity gap offers a quick look at the risk profile of a bank.

Despite its nature as a relatively short-term instrument, liquidity gap analysis is commonly used as the basis for scenario analysis and stress tests. ALM teams can, for example, track gap risk exposure by using maturity and cash-flow mismatches, taking into account not only the maturity dates of assets and liabilities but, just as importantly, intermediate cash flow position by testing for loan prepayments, for example, or the unforeseen use of lines of credit.

How do banks do this? The first step is to determine the length and number of each time interval to be used. The next is to define the maturities of both assets and liabilities, ideally by taking into account both normal and stress conditions. For assets that don't mature such as credit card balances, for example, teams make some assumptions based on historical trends. The next step is to put every asset and every liability into an appropriate time slot. The aim of this analysis is to avoid any imbalances by adapting the bank's future strategy to the actual and predicted conditions and the size and nature of the liquidity gap.

Liquidity Planning

Effective liquidity planning is a recurrent theme for the BCBS, and regulators who follow the Basel Committee's standards. Banks should have carefully crafted liquidity plans in place. It is up to regulators to evaluate the liquidity plans of individual institutions and to intervene quickly to deal with any deficiencies that could jeopardize the institutions themselves, and the financial system as a whole. This intervention could take many forms, from requiring that institutions strengthen their liquidity management practices—such as their internal policies, controls and reporting—to requiring that banks improve their contingency planning or lower their liquidity risk by keeping greater reserves. At other times, the regulator can block institutions from making acquisitions that could risk the systemic access to liquidity.

At its very core, the aim of liquidity planning is to put in place a strong liquidity framework that can withstand risk events. Both the board of directors and senior management should understand the risks that the institution faces and the strategies in place to deal with risk and the eventual risk event. Stress testing plays a key role in setting up these plans.

Another important component of an effective liquidity plan is to be ready for contingencies. Common sense dictates that any liquidity contingency plan goes hand in hand with plans to ensure adequate access to capital. Contingency planning should take into account changing conditions, including higher costs of liquidity or difficulties in accessing it in the event of changing conditions.

A third factor to consider is the relationship and interplay between assets, liabilities, liquidity and capital. Since the Global Financial Crisis (GFC), more banks have committees to manage their balance sheets, with senior executives at the helm. The ALCO may report to this higher-level committee. Its goal is to effectively manage this interplay and to bring all data together for analysis under one umbrella, so to speak.

New data management tools make this process somewhat easier, or at least faster. Banks and other financial institutions are more complex than ever before, but the tools exist to manage this complexity more efficiently.

Funds Transfer Pricing

Funds transfer pricing (FTP) is one approach that banks can use to measure how each individual source of funds contributes to overall profitability. Banks often use FTP to identify strengths and weaknesses in terms of funding in their organization. To be effective and balanced, an ALM strategy has to rely on a diversified funding base, and this means that FTP is necessary, particularly when a company has multiple divisions, or hundreds in the case of a large bank. FTP is a key tool to manage liquidity risk within a bank's balance sheet. It is very difficult, in practical terms, to completely neutralize risk exposures. The constant cycle of crises would seem to amply make this point. One thing bank, or the various businesses within them, can do is ensure they obtain funds at a rate that matches their ALM needs. This internal funding rate can then be described as ‘the rate at which a business line obtains its funds’.

There are two main reasons why a carefully crafted FTP strategy is important. One is that it enforces a certain discipline and risk control within a business. The second is that it has a direct impact on the returns that a particular line of business can generate.

The FTP mechanism operates as part of a larger risk management structure that considers both assets and liabilities and is, generally, centralized within Treasury operations. Given the complicated balance sheets of most banks, a number of risks are immediately visible. A couple of such risks can be partially addressed through an effective FTP mechanism. The first is interest rate risk. Interest rates fluctuate daily, which means that the daily liabilities of particular units could also fluctuate daily, each of these units requires an internal source of funds that is responsive enough to deal with these daily fluctuations. A second type of risk is liquidity risk. Most bank units require that their assets be constantly funded and that the funding be continuous and rolling; again, this requires an effective FTP mechanism.

An effective FTP mechanism should also take into account capital reserve requirements, not necessarily just meeting the daily needs of units but ensuring their proper capitalization. But implementing an FTP strategy can be challenging due to both regulatory constraints and internal controls at banks. At the heart of an effective FTP strategy is the idea that the costs of risk that appear in ALM are charged explicitly to businesses, products or customers, and tracked by the Treasury.

This internal funding structure helps better manage liquidity and liquidity risk for each business line, all the while minimizing risk exposures. In short, as Anthony Dalessandro explains, FTP helps banks centralize both the measurement and management of interest rate risk, ensure consistent product pricing guidelines for business lines, set profitability targets and measure the profitability of business units independently of interest rate risk.

But to do all this, FTP has to be implemented in a curve that moves along with changes in interest rates and the needs of individual business units. It has to take into account liquidity mismatches, the potential cost of liquidity risk and such diverse items as forex risks or capital controls.

Stress Tests

Stress tests are keyways for regulators to ensure the strength of their banking sectors. They can help determine whether banks are strong enough to make it through financial and economic crisis without bending or breaking. In carrying out stress tests, regulators identify risk factors and possible events that can affect the credit worthiness of banks and other institutions.

The US Federal Reserve, for example, instituted a Comprehensive Liquidity Analysis and Review mechanism in 2012 for the largest banks. The mechanism is, basically, a series of stress tests.

It is important not just to carry out the stress tests but for both banks and regulators to use the results to strengthen liquidity plans and the banking system as a whole. Institutions should use the tests to determine their strategy and tactics to shore up their liquidity risk planning and be in a better position to deal with events of liquidity stress. Tests should take into account not only multiple scenarios but also different time horizons and changes in the economic and systemic context.

The aim of stress tests is for banks to analyze how their operations and plans would hold up under different scenarios and how different events would impact each unit and the institutional group, particularly given that business lines are often intertwined. By carrying out stress tests banks may better understand where the risks are and how risk events could affect them. The results of a particular test could help both the bank and the regulatory authority to determine if more tests are needed or whether tests on individual business lines, branches or subsidiaries are warranted.

The extent and frequency of the stress tests should vary depending on the size of a bank and its liquidity exposure as well as changing conditions. Since the introduction of Basel III, banks have been encouraged to build into their systems the ability to carry out more frequent tests, particularly when circumstances change, market conditions become more volatile or when regulators request them.

Banks should also consider that their operations are never in a bubble. Counterparties, both competing institutions and clients, typically respond to risk events and these responses should be considered.

Under normal circumstances stress tests should consider events that are relatively common in markets, such as a drying up of liquidity, constrained accessing of secured and unsecured funding, existing restriction on currency convertibility and disruptions to the operations of payment or settlement systems that could be caused by a wide variety of incidents from changes to regulations to market sentiment or even natural disasters. Some events may not only limit access to liquidity but could also lead to a surge in the amount of liquidity that is required over a short period of time. A particularly important consideration is the link between market liquidity and any constraints on funding liquidity, particularly for banks that rely on a specific funding market.

The BCBS outlines a number of assumptions that banks should use in stress tests, including:

• asset liquidity and an erosion in the value of liquid assets.
• run-off of retail funding.
• availability of funding sources, both secured and unsecured.
• the correlation between funding markets and diversification of funding sources.
• margin calls and collateral requirements.
• funding tenors.
• potential draws on committed lines of credit.
• liquidity taken up by off-balance-sheet activities.
• availability of lines extended to the bank.
• credit rating triggers.
• FX convertibility and access to markets.
• the ability to transfer liquidity across entities, sectors and borders.
• access to central bank facilities.
• the bank's operational ability to monetize assets.
• remedial actions in place and the ability of the bank to execute them; and estimates of future balance sheet growth.

Stress tests based on the normal course of business are important, but rarely do institutions fail under such conditions. It is when conditions change that liquidity plans are tried. When designing stress tests, banks should consider abnormal circumstances, using historical context and stretching that out. The liquidity position of a bank or other financial institution can be rapidly affected during a crisis and, to be effective, stress testing should take crisis scenarios under consideration as well.

So we can summarize Liquidity Management as follows: -

• Liquidity is key to the operations of banks and other financial institutions. The need for liquidity may, at times, override profitability when it comes to planning the future of a bank.
• Effective liquidity controls are a key component of effective asset and liability management (ALM).
• Liquidity risk is the risk that a bank or other financial institution may be unable to meet its obligations as they fall due.
• There is virtually no transaction or commitment that a bank might undertake that does not impact its liquidity position in some way. And, if the liquidity position of one bank or one institution is affected, so is the market as a whole.
• Basel III, the latest series of agreements that guide most bank regulation around the world, includes a set of principles for the management and supervision of liquidity risk. Basel III liquidity rules require banks to hold high quality liquid assets (HQLA) in their balance sheets. These assets are usually linked to fixed income, currency and commodity (FICC) products that may be less profitable than riskier over the counter (OTC) products or derivatives.
• The Basel III rules on capital management and liquidity management are being phased in over several years to 2017. The BCBS provides 15 principles for the management and supervision of liquidity risk.
• The liquidity coverage ratio (LCR) measures the amount of high quality liquid assets that banks have on hand to withstand a 30-day stressed funding scenario specified by supervisors.
• The aim of the LCR is to strengthen capital and liquidity regulations and shore up not only individual banks but also entire banking systems, the weaknesses of which have become clear since 2008.
• There are two kinds of HQLA assets considered under the LCR. Level 1 assets include cash, central bank reserves and some marketable securities backed by sovereigns and central banks. Level 2 assets are of lower quality. They are further subdivided into Level 2A and Level 2B. Level 2A assets include some government securities, covered bonds and corporate securities.
• The Net Stable Funding Ratio (NSFR) requires banks to ‘maintain a stable funding profile in relation to the composition of their assets and off-balance-sheet activities’.
• The Asset-Liability Committee (ALCO) is a risk management committee made up of senior management executives. Its primary goal is to evaluate, monitor and approve the various practices of the bank with a view to the risk they pose of creating imbalances in the bank's capital structure. In other words, the ALCO is key to ensuring that banks and other AIs are well funded.
• The reserve requirement ratio (RRR) is the portion of depositors' balances that banks have to keep on hand as cash or cash equivalents, basically capital in reserve. Banks may hold excess reserves, but the RRR determines the minimum amount that they should hold. Not many regulators still use the RRR, having switched to the LCR and the NSFR, instead.
• A liquidity gap is the difference between the assets and liabilities that a bank—or any firm, really—has. This gap is caused by the different properties that assets and liabilities might have. It can be positive or negative, depending on the balance sheet of a particular institution. The aim of effective liquidity planning is to ensure a positive gap at all times.
• Funds transfer pricing (FTP) is used to measure how every individual source of funds contributes to overall profitability. Banks often use FTP to identify strengths and weaknesses in terms of funding in their organization. FTP is a key tool to manage liquidity risk within a bank's balance sheet.
• Stress tests are keyways for regulators to ensure the strength of their banking sectors. They can help determine whether banks are strong enough to make it through financial and economic crisis without bending or breaking. In carrying out stress tests, regulators identify risk factors and possible events that can affect the credit worthiness of banks and other institutions.