1.

INTRODUCTION Liquidity

risk is the current and potential risk to the earnings and market value of shareholders equity. Liquidity risk arises from a banks inability to meet its payment obligations in a timely and cost effective manner. It arises on both the asset side and the liability side of the balance sheet of a bank. Liability side liquidity risk arises when the liability holders of the bank i.e. the depositors seek to withdraw their financial claims immediately. The bank needs to borrow additional funds or sell its assets or run down its cash assets in order to meet the claims of its borrowers, which gives rise to a liquidity deficit in the bank. On the asset side of the balance sheet, liquidity risk arises in the banks when the Cash Credit and the overdraft limits are drawn down, which creates immediate liquidity pressure. The bank strives to meet the liquidity shortage by way of borrowings from the call money market or it sells off other liquid assets. Liquidity management is a day to day responsibility for the banks. Banks consistently experience fluctuations in their liquid assets, depending on the frequency and magnitude of unanticipated deposit outflows. The shortages are mostly met by way of planned borrowings or delayed asset purchases. On the other hand, the excessive cash can be deployed in the earning assets. Managing the liquidity risk on both the asset side and the liability side of the balance sheet is referred to as the AssetLiability Management in banks. Banks rely on both assets and liability sources of liquidity. The small banks, which have a comparatively lower credibility than the larger banks, have limited access to purchased funds. They mostly rely on the short term assets for their interest earnings. The larger banks obtain liquid funds from their liabilities, which are low cost core deposits rather than selling assets. Thus, the Asset Liability management strategy for different banks varies with its asset quality, capital base, composition of deposits and other liabilities. The traditional approaches to liquidity measures focus on balance sheet accounts and measure liquidity for a bank in terms of its financial ratios. The approaches predicted the stock of liquidity in banks balance sheet. There was a need to capture the liquidity flows in the balance sheet of the banks. The Reserve Bank had issued its first guidelines on ALM in Feb, 1999. As a measure of liquidity management, the banks were required to monitor their future cash inflows in the asset side and future cash outflows in the liability side by slotting all the maturing assets and the maturing liabilities in time buckets in their Structural Liquidity Statements. The liquidity statements, prepared on daily basis would provide a dynamic picture of the banks changing liquidity patterns and hence would be more effective in determining the liquidity risk in the balance sheet of the banks when compared to traditional approaches of liquidity measurement.

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1.1 WHAT IS LIQUIDITY RISK? There are two kinds of liquidity: market liquidity and funding liquidity

A security has good market liquidity, if it is easy to trade, i.e. has a low bid-ask spread, small price impact, high resilience, easy search in OTC markets. A bank or investor has good funding liquidity if it has enough available funding from its own capital or from (collateralized) loans. Funding Risk It is the need to
replace net outflows due to unanticipated withdrawals/non-renewal of deposits (wholesale and retail

In other words, market liquidity risk is the risk that the market liquidity worsens when you need to trade whereas funding liquidity risk is the risk that a trader cannot fund his position and is forced to unwind. Effective liquidity management entails three elements: Assessing, on an ongoing basis, the current and expected future needs for funds, and ensuring that sufficient funds or access to funds exists to meet those needs at the appropriate time. Providing for an adequate cushion of liquidity to meet unanticipated cash flow needs that may arise from a continuum of potential adverse circumstances that can range from high-probability/low-severity events that occur in daily operations to lowprobability/high-severity events that occur in less frequently but could significantly affect an institutions safety and soundness. Striking an appropriate balance between the benefits of providing for adequate liquidity to mitigate potential adverse events and the cost of that liquidity.

The liquidity managers have an array of alternative sources of funds to meet their liquidity needs. The sources can be net operating cash flows, liquidation of assets, generation of liabilities and increase in capital funds.

1.2 IMPORTANCE OF LIQUIDITY RISK MANAGEMENT Liquidity risks is inherent in banks core business because banking organizations employ a significant amount of leverage in their business activities and need to meet contractual obligations in order to maintain the confidence of customers and fund providers. Adequate liquidity is critical to an institutions ongoing operation, profitability, safety and soundness. Recent events have shown that, different types of risks can and do impact on each other. In fact, during times of financial crisis, risks have repeatedly shown a tendency to transform from one type to another with breathtaking speed.

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2. SCOPE OF THE PROJECT:

The project aims to study the Structural Liquidity Statements of different banks and determine their efficiency in managing their liquidity risk. The study will focus on analyzing trends and patterns in the Indian public sector and private sector banks. A comparative analysis of the large banks, mid size banks and the small banks can be done, which have different balance sheet sizes and determine how they manage their liquidity deficits and surplus. Scenarios can be generated for different situations and depending upon how long the stress period is going to last, its effect on the banks ability to meet the liquidity deficits can be determined.

3. REVIEW OF LITERATURE:
Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring huge losses. The fundamental role of banks in the maturity transformation of short-term deposits into long-term loans makes banks inherently vulnerable to liquidity risk. Effective liquidity risk management helps ensure a bank's ability to meet cash flow obligations. Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management. The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and individual institutions as well. In February 2008, the Basel Committee on Banking Supervision published Liquidity Risk Management and Supervisory Challenges. The difficulties outlined in that paper highlighted that many banks had failed to take account of a number of basic principles of liquidity risk management when liquidity was plentiful. Most of the banks did not have an adequate framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines.

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Many banks had not considered the amount of liquidity they might need to satisfy contingent obligations as they viewed funding of these obligations to be highly unlikely. Many firms viewed severe and prolonged liquidity disruptions as implausible and did not conduct stress tests. Contingency funding plans (CFPs) were not always appropriately linked to stress test results and sometimes failed to take account of the potential closure of some funding sources.

In order to account for financial market developments as well as lessons learned from the crisis, the Basel Committee conducted a fundamental review of its Sound Practices for Managing Liquidity in Banking Organisations. Specific guidelines were given on key areas, like - the importance of establishing a liquidity risk tolerance; the maintenance of an adequate level of liquidity, through a cushion of liquid assets; public disclosure in promoting market discipline. Guidelines were also issued for the supervisors which emphasized assessing the adequacy of banks liquidity risk management framework and its level of liquidity. The guidelines focussed on liquidity risk management for different sized banks and their nature of businesses. 3.1 RBI GUIDELINES: Liquidity can be measured through stock and flow approaches. The key ratios adopted across the banking system are: Loan to total assets Loans to core deposits Large liabilities (minus) temporary investments to earning assets (minus) temporary investments, where liabilities represent wholesale deposits which are market sensitive and temporary investments are those maturing within one year and those investments which are held in the trading book and are readily sold in the market. Purchased funds to total assets, where purchased funds include the entire interbank and other bank market borrowings, including certificate of deposits and institutional deposits; and Loan losses to net loans

While liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal intrinsic liquidity profile of Indian banks which are operating generally in the illiquid market. It is commonly assumed that government securities and other money market instruments are liquid but their liquidity is limited as the market and the players are unidirectional. Thus, the analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of
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maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM system should be adopted for measuring cash flow mismatches at different time bands. The banks need to analyse the behavioural maturity profile of various components of on/off balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. The assumptions should be fine tuned over a period which facilitate near reality predictions about future behaviour of on/off balance sheet items. Apart from the above cash flows, banks should also track the impact prepayment of loans, premature closure of deposits and exercise options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which the liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest dates contingencies could be crystallized. Bank management should measure not only the liquidity positions of banks on an ongoing basis but also examine how liquidity requirements are likely to evolve under crisis scenarios. The Reserve Bank had issued its first guidelines on ALM in Feb, 1999. As a measure of liquidity management, the banks were required to monitor their future cash inflows in the asset side and future cash outflows in the liability side by slotting all the maturing assets and the maturing liabilities in time buckets in their Structural Liquidity Statements. The time buckets were divided into 1 14 days, 15 28 days, 29 days 3 months, 3 months 6 months,6 months 12 months,1 yr 3 yrs, 3yrs 5 yrs and above 5 years bucket. As per the guidelines, the negative gaps in the first two buckets were not to exceed 20% of the cash outflow in the respective time buckets. Keeping in view the Basel guidelines, the above guidelines were reviewed on October 24, 2007 and it was recommended by RBI, to adopt a more granular approach, by splitting the first time bucket into next day, 2 7 days and 8 14 days buckets. The cumulative negative gaps could not exceed 5%, 10% and 15% of the cash outflows for the respective buckets. By monitoring the cumulative negative gaps, the banks could use the surplus in earlier buckets to reduce deficits in later buckets. Under the ALM guidelines, the banks are expected to undertake dynamic liquidity management and prepare the Structural Liquidity Statements on a daily basis. The cash inflows and outflows are placed in the buckets based on their behavioural maturity rather than their residual maturity. The outflows like Capital, Reserves and surplus are placed in the long term buckets, while the demand liabilities like the savings and current account deposits are placed in the short term buckets. Term deposits, CDs and borrowings are placed in their respective maturity buckets. On the inflow side, cash and other statutory reserves are placed in the short term buckets, while the cash credits and overdrafts occupy the buckets depending on their core portion and the volatile portions. The volatile portions occupy the short term buckets while the core portions are placed in the longer term buckets. Term loans are placed in their respective maturity buckets. The liquidity risk limits of 5%, 10%, 15% and 20% as a fraction of liabilities assume a conservative value of tradable assets. Banks, which are reliant on the short term funding

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could actively monitor the first few buckets and frame long term strategies by monitoring the subsequent buckets by altering their portfolio to change their liquidity conditions.

3.2 GUIDELINES ON LIQUIDITY RISK MANAGEMENT Basel III has proposed two ratios to be maintained by banks, for liquidity risk management under stress scenarios. They are: Liquidity Coverage Ratio(LCR) and the Net Stable Funding Ratio(NSF). Liquidity coverage ratio This metric aims to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors. At a minimum, the stock of liquid assets should enable the bank to survive until day 30 of the proposed stress scenario, by which time it is assumed that appropriate actions can be taken by management and/or supervisors, and/or the bank can be resolved in an orderly way. The Liquidity Coverage Ratio (LCR) builds on traditional liquidity coverage ratio methodologies used internally by banks to assess exposure to contingent liquidity events. Net cumulative cash outflows for the scenario are to be calculated for 30 calendar days into the future. The standard would require that the value of the ratio be no lower than 100% (i.e. the stock of liquid assets should at least equal the estimated net cash outflows).

In summary, the stress scenario specified incorporates many of the shocks experienced during the current crisis into one acute stress for which sufficient liquidity is needed to survive up to 30 calendar days. This stress test should be viewed as a minimum supervisory requirement for banks. Banks are still expected to conduct their own stress tests to assess the level of liquidity they should hold beyond this minimum, and construct scenarios that could cause difficulties for their specific business activities. Such internal stress tests should incorporate longer time horizons than the ones mandated by this standard. Banks are expected to share these additional stress tests with supervisors. The proposed standard should be a key component of the regulatory approach, but must be supplemented by detailed supervisory assessments of other aspects of the banks liquidity risk management framework in line with the Committees Sound Principles. The LCR consists of two components: Value of the stock of high quality liquid assets in stressed conditions and Net cash outflows, calculated according to the scenario parameters set by supervisors. The numerator of the LCR is the stock of high quality liquid assets. Under the proposed standard, banks must hold a stock of unencumbered, high quality liquid assets which is clearly sufficient to cover cumulative net cash outflows (as defined below) over a 30-day period under the prescribed stress scenario. As supported by the Financial Stability Board in its September 2009 report to the G20, the LCR establishes a harmonised framework to ensure that global banks have sufficient high-quality liquid assets to withstand a stressed
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scenario (as set out in the LCR). In order to qualify as a high-quality liquid asset, assets should be liquid in markets during a time of stress and, ideally, be central bank eligible. The 2007-2009 crises reinforced the need to examine carefully the liquidity of asset markets, and, the characteristics that allow some markets to remain liquid in times of stress. Banks need to be careful not to be misled by the wide range of liquid markets during booms. Assets are considered to be high quality liquid assets if they can be easily and immediately converted into cash at little or no loss of value. The liquidity of an asset depends on the underlying stress scenario, the volume to be monetised and the time-frame considered. Nevertheless, there are certain assets that are more likely to generate funds without incurring large fire-sales even in times of stress. Net stable funding ratio (NSFR or NSF ratio) The net stable funding ratio has been proposed within Basel III, the new set of capital requirements for banks, which will over time replace Basel II. This funding ratio seeks to calculate the proportion of long-term assets which are funded by long term, stable funding. Stable funding includes: customer deposits, long-term wholesale funding (from the Interbank lending market), and Equity. "Stable funding" excludes short-term wholesale funding (also from the interbank lending market). Long term assets or "structural term assets" means: 100% of loans longer than one year; 85% of loans to retail clients with a remaining life shorter than one year; 50% of loans to corporate clients with a remaining life shorter than one year; and 20% of government and corporate bonds; off-balance sheet categories are also weighted.

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4. METHODOLOGY:
The methodology will include sensitivity analysis of the liquidity statements of the public sector banks and the new private sector banks. It will include restructuring the balance sheet of the banks to manage the liquidity risk. Scenarios with growing or shrinking the balance sheet size will be included to observe its effect on liquidity management of the banks. It will be followed by a trend analysis of the liquidity statements from 31 st March, 2005 to 31st March, 2011. The balance sheet patterns of different small size, mid- size and large size banks will be observed to identify the strategies undertaken by the banks to manage the liquidity risk in their banking books.

4.1 IDENTIFICATION OF VARIABLES/DATA SOURCES: The liquidity statements of banks can be obtained from the secondary data sources like Annual reports of banks FY 2005 to FY 2011. Reserve Bank of India website. Respective websites of the banks.

4.2 TOOLS/TECHNIQUES: Analysis and data interpretation tools can be used to analyse the data. Sensitivity analysis can be undertaken by simple scenario analysis tools available under MS office Excel sheets. Trend analysis and patterns observed under it can be shown by way of graphs, bar diagrams and charts.

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5. ANALYSIS AND INTERPRETATION:

The Structural Liquidity Statements, under the Basel guidelines are referred to as the Maturity Ladder Approach. In the Indian Banking scenario, till 2007 there was hardly any CDs issued by the banks. Post 2007, there was a sudden explosion of CDs which added to the liquidity pressure on the liability side. The deposit base became shorter and unstable. It created more demand for short-term deposits and hence also reduced the maturity pattern of the investments or the asset side. The Structural Liquidity Statements obtained from the banks are in aggregated form. The deposits shown include the current account deposits, savings deposits and the term deposits. On the investment side, we have the SLR and the non-SLR investments. Similarly, the Advances include the Cash Credit/Overdraft and the term loan facilities. Consider the SLS of a bank, at the year end March 2006:

SLS of a Typical Bank STATIC LIQUIDITY GAP SUMMARY (Rs. in Crores) as on 31.3. 2006 PARTICULARS 1D15-28 29 D 3-6 6-12 1-3 Y 3-5 Y OVER 14D D TO 3 M M 5Y M 1174 3854 10864 7946 Deposits 49404 4520 9855 9 9 6 6 77856 Borrowings 9501 2903 2750 4883 1805 3861 4588 350 Foreign Currency 1032 1064 1028 Liabilities 19844 5688 7 5 6 8414 4964 770 Total 2293 2727 5064 12092 8901 Liabilities 78749 13111 3 7 0 1 9 78976 1380 1160 1027 10943 2205 Advances 42550 4746 6 8 0 3 5 47331 2992 Investments 1044 2245 8544 4806 2061 28351 6 85556 Foreign Currency 1359 Assets 22098 4983 7 7698 4934 9813 6868 2202 3594 2411 1726 14759 5885 13508 Total Assets 65691 11975 8 3 5 7 0 9 1301 - 3337 3016 Gap 13058 -1136 6 3164 5 26675 9 56113 Cumulative - 3771 - 4121 Gap 13058 -14194 1178 4343 8 11043 2 14901 Gap/Outflows - -8.67% 9| Page

Cum. Outflow Cum. Gap/Cum. Outflow

16.58 % 78749 91860 16.58 % 15.45%

The first bucket, i.e. 1-14 days bucket, shows a negative gap of Rs. 13058 crores. The negative gap shows a funding liquidity deficit in its Banking Book. It means that the bank is required to pay an amount of Rs. 13058 crores in the next 1-14 days. . In case, there was a positive gap, the bank would have a funding liquidity surplus in the next 1-14days. The interest payables should also be included in the liquidity statements, since the interest components can be reinvested at the going rates. Similarly, the unutilized portions of the CC/OD must be considered as outflows since there is a possibility of withdrawal in the future and the utilized limits must be considered as inflows since there is a possibility of interest receipts in the future. The banks prepare their Structural Liquidity Statements, to understand the strengths and the weaknesses of the existing balance sheet and move to more preferred positions in the future.

5.1 Trend Analysis: A simple trend analysis of the Structural Liquidity Statements can be generated from the data obtained from the annual reports of different Public Sector Banks and the New Private Sector Banks. When the SLS of a bank across the years are arranged side by side, we can detect certain patterns in the balance sheet of the banks. Suppose, if the fraction of deposits maturing in less than 1 year is steadily increasing even in the rising rate scenario, we cannot relate the balance sheet pattern to the changes in interest rates.

Bank-Group wise analysis: Deposits and borrowings: When we look at the deposits and the borrowings maturity profile, we find that on an average, SBI and associates have 10% of the deposits maturing within 1 month, but the new private sector banks have on an average 12% of the deposits maturing within 1 month. The new private sector bank group has more of shorter term deposits as compared to other PSBs and SBI. The savings and current account deposits are placed in the buckets as per their behavioural maturity. 10% of the savings deposits are considered to be volatile and 15% of the current account deposits are volatile, which are placed in the 1-14 days bucket. The core portion of the savings deposits and current account deposits are placed in buckets above 1-3 years bucket.
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In March 2009, we find positive gaps in 1-14 days bucket in SBI and associates followed by negative gaps in 15-28 days bucket. When we monitor the deposits and borrowings maturing within 1 year, we find that, almost 40% of the deposits in PSBs are maturing within 1 year whereas in new private sector banks, almost 55% are maturing within 1 year. The SBI and other PSBs have a more stable base of low cost deposits, core portion of the CASA deposits.

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Advances and Investments: In the advances and the investment portfolio, 55-60% of the advances of the New Private Sector Banks are maturing within 1 year, whereas in the other PSBs and SBI group, only 20% investments are in the short term. From the March 2009 data, we find that 50% of the investments in the PSBs are in the above 5 year bucket where as in the private sector banks, 55-60% is in below 1 year buckets. Since the public sector banks have more stable and larger base of deposits, they have long term investments.

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Bank-Size wise Analysis: The banks are grouped as per their total business size as on March 2011. The banks with business size Rs. 3 lakh crore and above are Large size banks, the banks with total business size between 1 lakh and 3 lakh crore are mid-size banks and the banks with business size below 1 lakh are small size banks.

Deposits and Borrowings:

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The deposits and borrowings maturing in less than 1 month for the large size banks have shown a sudden rise in the year 2009. The reverse scenario has been found in the small size banks. The mid-size banks have shown a more or less stable trend in the seven year from March 2005 to March 2011. Similar patterns have been observed in small size banks when the deposits maturing in less than 1 year trend was observed.

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Interpretation of results: As compared to SBI and other nationalized banks, the private sector banks have more of shorter term and unstable deposits. On the asset side, the private sector banks rely on short term assets and investments, where SBI and other PSBs have long term investments above 5 years. Large size banks have larger deposit base than small size banks. On the asset side as well, they have more of longer term investments than the small size banks.

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5.2 Scenario Analysis: Banks are expected to meet liquidity requirement continuously and hold a stock of unencumbered, high quality assets as a defence against the potential onset of severe liquidity stress. Banks and supervisors are also expected to be aware of any potential mismatches within the 30-day period and ensure that sufficient liquid assets are available to meet any cash flow gaps throughout the month. The scenario proposed for this standard entails a combined idiosyncratic and market-wide shock which would result in: a three-notch downgrade in the institutions public credit rating; run-off of a proportion of retail deposits; a loss of unsecured wholesale funding capacity and reductions of potential sources of secured funding on a term basis; loss of secured, short-term financing transactions for all but high quality liquid assets; increases in market volatilities that impact the quality of collateral or potential future exposure of derivatives positions and thus requiring larger collateral haircuts or additional collateral; unscheduled draws on all of the institutions committed but unused credit and liquidity facilities; and The need for the institution to fund balance sheet growth arising from noncontractual obligations honoured in the interest of mitigating reputational risk.

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Scenario 1: Consider there is a 1% hike in the rates and the stress period lasts for 3 months, where 20% of the deposits will be withdrawn. After 14 days, the 15-28 day bucket will become the 1-14 day bucket, and on 28th day, 29 days - 3 months bucket will come in the first bucket. Since, the stress period lasts for 3 months, 3 m 6m bucket becomes the first bucket after 3 months. The stress will affect the liability side of the balance sheet Scenario Results: Large Size Bank 1D-14D Gap/Outflows Base Scenario Cum. Outflow Gap/Cum. 1.89% -59.1% -59.1% -5.60% -89.2% -69.9% -6.28% -53.7% -65.4% 1.89% 15-28 D -37.21% 29 D TO 3 M -7.41%

Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum.

Mid Size Bank 1D-14D Gap/Outflows Base Scenario Cum. Outflow Gap/Cum. 16.95% -62.0% -62.0% -1.32% -80.3% -69.4% -18.70% -45.1% -61.3% 16.95% 15-28 D -31.59% 29 D TO 3 M -32.09%

Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum.

Small Size Bank 1D-14D Base Scenario Gap/Outflows -66.72% 15-28 D -30.33% 29 D TO 3 M -17.31%

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Cum. Outflow

Gap/Cum. -66.72% -83.3% -83.3% -55.31% -71.0% -78.9% -35.49% -9.3% -56.7%

Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum.

Scenario 2: Under the stress period which will last for 3 months, the bank will try to increase its cash inflows to meet the funding liquidity deficits by sale of assets. The assets will be sold at a value 5% less than the face value. Hence the cash inflows will be re-valued at 95% of the asset value. This will further add stress to the asset side of the balance sheet. Scenario Results: Large Size Bank 1D-14D Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum. -59.1% -61.18% -61.18% -69.9% -89.79% -71.39% -65.4% -56.05% -67.13% -59.1% 15-28 D -89.2% 29 D TO 3 M -53.7%

Gap/Outflows Scenario 2 Cum. Outflow Gap/Cum.

Mid Size Bank 1D-14D

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15-28 D

29 D TO 3 M

Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum.

-62.0% -62.0% -63.86% -63.86%

-80.3% -69.4% -81.31% -70.94%

-45.1% -61.3% -47.85% -63.26%

Gap/Outflows Scenario 2 Cum. Outflow Gap/Cum.

Small Size Bank 1D-14D Gap/Outflows Scenario 1 Cum. Outflow Gap/Cum. -83.3% -84.14% -84.14% -78.9% -72.45% -79.99% -56.7% -13.83% -58.89% -83.3% 15-28 D -71.0% 29 D TO 3 M -9.3%

Gap/Outflows Scenario 2 Cum. Outflow Gap/Cum.

Interpretation of result: It was observed that under stress conditions, there are wider gaps in the first 3 buckets.(stress period lasts for 3 months). As compared to the base scenario, the positive gaps in the 1-14 day bucket widen to large negative gaps. The gaps are calculated as a percentage of total cash outflows in the first bucket. In the scenario 2, where the stress shock is given on the asset side as well, the gap further widens in the first bucket followed by the cumulative gaps in the subsequent buckets. The effect of the stress shock is worse on the mid size banks, where the gaps are wider. The situation is worst in the case of the small size banks. The gaps become still wider when the same exercise is repeated in the case of the small size banks.

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6. CONCLUSION & RECOMMENDATIONS:

Liquidity risk management is of paramount importance because a liquidity shortfall at a single institution can have system-wide repercussions. Financial market developments in the past decade have increased the complexity of liquidity risk and its management. The market turmoil that began in mid-2007 re-emphasised the importance of liquidity to the functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time. The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and individual institutions as well. Simple Trend Analysis of the Structural Liquidity Statements suggested certain trends and patterns in the balance sheet of the banks when they were clubbed bank-group wise i.e. public sector banks and private sector banks. The liquidity risk management is different in different sized banks. The trends observed cannot be attributed only to the fluctuations in the interest rates. As compared to SBI and other nationalized banks, the private sector banks have more of shorter term and unstable deposits. On the asset side, the private sector banks rely on short term assets and investments, where SBI and other PSBs have long term investments above 5 years. Large size banks have larger deposit base than small size banks. On the asset side as well, they have more of longer term investments than the small size banks. Scenario analysis created stress situations for the banks, and it was found that the banks did not have enough liquidity to reduce the deficits in the first three buckets, even when the stress period lasted for three months. The situation worsened for the mid-size and the small size banks. The banks must be prepared for the stress scenarios, and maintain enough liquidity to sustain its business for the next 30 days. It must maintain a high liquidity coverage ratio to sustain periods of stress. The structural liquidity statements can be effective used to monitor the strengths and weaknesses of the existing balance sheet of the banks and aids the banks in moving to its preferred positions in the future.
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7. SUGGESTIONS FOR FUTURE RESEARCH:

A more granular approach can be taken, by dividing the 1-14 days bucket into next day, 2-7 days and 8-14 days. The funding liquidity deficit on each bucket can be determined more effectively, if the short term buckets are broken in shorter periods. The gaps/outflow ratio can be monitored more effectively if the first bucket is broken into still smaller parts. The only constraint in the project was data availability from 2005 to 2008. Since, RBI issued its revised guidelines on October 24, 2007 some of the banks could not prepare the structural liquidity statements as per the new guidelines till 2008. The data on next day, 2-7 days and 8-14 days was available from March 2009. A similar trend analysis can be conducted from 2009 to detect patterns and study them.

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8. EXECUTIVE SUMMARY:
Liquidity risk arises from a banks inability to meet its payment obligations in a timely and cost-effective manner and also from the inability to deploy its surplus funds. In the balance sheet of the bank, it arises on both the asset side and the liability side of the balance sheet. On the asset side, CC/ OD limits are drawn down, which creates immediate liquidity pressure. The bank strives to meet the liquidity shortage by way of borrowings from the call money market or it sells off other liquid assets. On the liability side, deposit holders of the bank seek to withdraw their financial claims immediately. The bank needs to borrow additional funds or sell its assets in order to meet the claims, which gives rise to a liquidity deficit in the bank. Managing the liquidity risk on both the asset side and the liability side of the balance sheet is referred to as the Asset-Liability Management in banks. Banks rely on both assets and liability sources of liquidity. Small banks have limited access to purchased funds and mostly rely on the short term assets for their interest earnings. Large banks obtain liquid funds from their liabilities, which are low cost core deposits rather than selling assets.
The Reserve Bank had issued its first guidelines on ALM in Feb, 1999. A s a measure of liquidity

management, the banks were required to monitor their future cash inflows in the asset side and future cash outflows in the liability side by slotting all the maturing assets and the maturing liabilities in time buckets in their Structural Liquidity Statements. As per RBI guidelines on Feb, 1999 the time buckets were divided into 1 14 days, 15 28 days, 29 days 3 months, 3 months 6 months,6 months 12 months,1 yr 3 yrs, 3yrs 5 yrs and above 5 years. The Negative gaps in first two buckets were not to exceed 20% of the cash outflow.
A simple trend analysis of the SLSs was generated from the data obtained from the annual reports of different Public Sector Banks and the New Private Sector Banks. When the SLS of a bank across the years are arranged side by side, we could detect certain patterns in the balance sheet of the banks.

The liquidity risk management is different in different sized banks. The trends observed cannot be attributed only to the fluctuations in the interest rates. Scenario analysis created stress situations for the banks, and it was found that the banks did not have enough liquidity to reduce the deficits in the first three buckets, even when the stress period lasted for three months. The situation worsened for the mid-size and the small size banks. The banks must
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be prepared for the stress scenarios, and maintain enough liquidity to sustain its business for the next 30 days. It must maintain a high liquidity coverage ratio to sustain periods of stress. The structural liquidity statements can be effective used to monitor the strengths and weaknesses of the existing balance sheet of the banks and aids the banks in moving to its preferred positions in the future.

REFERENCES:

http://www.bis.org/publ/bcbs144.htm www.rbi.org.in - RBI/2007-2008/165 DBOD. No. BP. BC. 38 / 21.04.098/ 2007-08

October 24, 2007

Working paper on ALM Dr. S.S. Sachidananda and D.N. Prahlad Centre of banking And IT

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