Understanding Monetary Policy Series No 34

CENTRAL BANK OF NIGERIA
UNDERSTANDING
MONETARY POLICY SERIES
NO 34
BANKING SYSTEM LIQUIDITY
Obiageri C. Ndukwe
POLICY DEPA
RY
TA
RT
MONE
MEN
10
TH
T
Anniversary
Commemorative c 2013 Central Bank of Nigeria
Edition
Central Bank of Nigeria
33 Tafawa Balewa Way
Central Business Districts
P.M.B. 0187
Garki, Abuja
Phone: +234(0)946236011
Fax: +234(0)946236012
Website: www.cbn.gov.ng
E-mail: info.dmp@cbn.gov.ng
ISBN: 978-978-52860-5-2
© Central Bank of Nigeria
Understanding Monetary Policy
Series 34, October 2013
EDITORIAL TEAM
EDITOR-IN-CHIEF
Moses K. Tule
MANAGING EDITOR
Ademola Bamidele
EDITOR
Charles C. Ezema
ASSOCIATE EDITORS
Victor U. Oboh
David E. Omoregie
Umar B. Ndako
Agwu S. Okoro
Adegoke I. Adeleke
Oluwafemi I. Ajayi
Sunday Oladunni
Aims and Scope

Understanding Monetary Policy Series are designed to improve monetary policy
communication as well as economic literacy. The series attempt to bring the
technical aspects of monetary policy closer to the critical stakeholders who may not
have had formal training in Monetary Management. The contents of the publication
are therefore, intended for general information only. While necessary care was
taken to ensure the inclusion of information in the publication to aid proper
understanding of the monetary policy process and concepts, the Bank would not
be liable for the interpretation or application of any piece of information contained
herein.
Subscription and Copyright

Subscription to Understanding Monetary Policy Series is available to the general
public free of charge. The copyright of this publication is vested in the Central Bank
of Nigeria. However, contents may be cited, reproduced, stored or transmitted
without permission. Nonetheless, due credit must be given to the Central Bank of
Nigeria.
Correspondence
Enquiries concerning this publication should be forwarded to: Director, Monetary
Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria,
Email:info.dmp@cbn.gov.ng
iii
Mandate
§Ensure monetary and price stability

§Issue legal tender currency in Nigeria
§Maintain external reserves to safeguard the international
value of the legal tender currency
§Promote a sound financial system in Nigeria
§Act as banker and provide economic and financial
advice to the Federal Government
Vision
“By 2015, be the model Central Bank delivering
Price and Financial System Stability and promoting
Sustainable Economic Development”
Mission Statement
“To be proactive in providing a stable framework for the
economic development of Nigeria through the
effective, efficient and transparent implementation
of monetary and exchange rate policy and
management of the financial sector”
Core Values
§Meritocracy
§Leadership
§Learning
§Customer-Focus
iv
MONETARY POLICY DEPARTMENT
Mandate
To Facilitate the Conceptualization and Design of

Monetary Policy of the Central Bank of Nigeria
Vision
To be Efficient and Effective in Promoting the

Attainment and Sustenance of Monetary and
Price Stability Objective of the
Mission
To Provide a Dynamic Evidence-based

Analytical Framework for the Formulation and
Implementation of Monetary Policy for
Optimal Economic Growth
v
FOREWORD
The understanding monetary policy series is designed to support the
communication of monetary policy by the Central Bank of Nigeria (CBN). The series
therefore, provides a platform for explaining the basic concepts/operations,
required to effectively understand the monetary policy of the Bank.
Monetary policy remains a very vague subject area to the vast majority of people; in
spite of the abundance of literature available on the subject matter, most of which
tend to adopt a formal and rigorous professional approach, typical of
macroeconomic analysis. However, most public analysts tend to pontificate on
what direction monetary policy should be, and are quick to identify when in their
opinion, the Central Bank has taken a wrong turn in its monetary policy, often
however, wrongly because they do not have the data for such back of the
envelope analysis.
In this series, public policy makers, policy analysts, businessmen, politicians, public
sector administrators and other professionals, who are keen to learn the basic
concepts of monetary policy and some technical aspects of central banking and
their applications, would be treated to a menu of key monetary policy subject areas
and may also have an opportunity to enrich their knowledge base of the key issues.
In order to achieve the primary objective of the series therefore, our target
audience include people with little or no knowledge of macroeconomics and the
science of central banking and yet are keen to follow the debate on monetary
policy issues, and have a vision to extract beneficial information from the process,
and the audience for whom decisions of the central bank makes them crucial
stakeholders. The series will therefore, be useful not only to policy makers,
businessmen, academicians and investors, but to a wide range of people from all
walks of life.
As a central bank, we hope that this series will help improve the level of literacy in
monetary policy as well as demystify the general idea surrounding monetary policy
formulation. We welcome insights from the public as we look forward to delivering
content that directly address the requirements of our readers and to ensure that the
series are constantly updated as well as being widely and readily available to the
stakeholders.
Moses K. Tule
Director, Monetary Policy Department
CONTENTS
Section One: Introduction .. .. .. .. .. .. 1
Section Two: Conceptual Issues in Banking System Liquidity

2.1 Liquidity .. .. .. .. .. .. .. 3
2.2 Capital and Liquidity Nexus .. .. .. .. .. 4
2.3 Liquidity: Regulatory Requirement .. .. .. .. 4
Section Three: Sources of Banking System Liquidity .. .. .. 7

3.1 Asset Management .. .. .. .. .. .. 7
3.2 Liability Management .. .. .. .. .. .. 7
3.3 Funding Sources: Assets .. .. .. .. .. 7
3.3.1 Asset Sale .. .. .. .. .. .. 7
3.3.2 Asset Securitization .. .. .. .. .. 8
3.3.3 Loan Portfolio and Loan Commitments .. .. 8
3.3.4 Investment Portfolio .. .. .. .. .. 8
3.4 Funding Sources: Liabilities .. .. .. .. .. 8
3.4.1 Deposits .. .. .. .. .. .. 8
3.4.2 Wholesale and Market Based Funding .. .. 9
3.4.3 Public Funds .. .. .. .. .. .. 9
3.4.4 International Funding Sources .. .. .. .. 9
3.4.5 Central Bank Funds .. .. .. .. .. 9
3.4.6 Interbank Borrowings .. .. .. .. .. 9
3.4.7 Repurchase Agreements Transactions .. .. 10
Section Four: Liquidity Risk .. .. .. .. .. .. 11

4.1 Red Flags to Declining Banking System Liquidity .. .. 11
4.1.1 High and Rising Interest Rates .. .. .. .. 12
4.1.2 Declining Deposit Money Banks' Closing Balances .. 12
4.1.3 Increased Demand for Secured Lending in the Interbank
Market .. .. .. .. .. .. .. 12
4.1.4 Increased Access to Central Bank Standing Lending
Facility .. .. .. .. .. .. .. 13
Section Five: Management of Banking System Liqudity in Nigeria 15

5.1 Monetary Policy Response to Deficit Banking System Liquidity
(The wake of the global financial crises 2008 - 2011) .. .. 15
5.2 Monetary Policy Response to Excess Liquidity in the Banking
System (2010 - 2014) .. .. .. .. .. .. 16
5.3 Policy Instruments Used by the Central Bank in Controlling Banking
System Liquidity .. .. .. .. .. .. 16
5.3.1 Cash Reserve Ratio .. .. .. .. .. 16
5.3.2 Liquidity Ratio .. .. .. .. .. .. 17
5.3.3 Loan to Deposit Ratio .. .. .. .. .. 17
5.3.4 Foreign Currency Trading Position .. .. .. 17
5.3.5 rDAS Introduction .. .. .. .. .. 18
vii
5.3.6 Implementation of TSA .. .. .. .. 18
Section Six: Conclusion .. .. .. .. .. .. 19
Glossary of Terms .. .. .. .. .. .. .. 21
Bibliography .. .. .. .. .. .. .. 23
viii
BANKING SYSTEM LIQUIDITY1
Obiageri C. Ndukwe2
SECTION ONE
Introduction
According to the modern theory on financial intermediation, the major reason for
the creation and existence of banks is to perform two central roles in the
economy –to create liquidity and transform risk. The important role banks play
through liquidity creation impacts on the larger economy by spurring growth in
the real sector.
Banks create liquidity on the balance sheet by financing less liquid assets with
funds from relatively liquid liabilities. Banking system liquidity is vital to the
sustainability of the financial system. Indeed a quick look into the global financial
market crises between 2007 and 2009 stresses this point. Tensions appeared in
global markets and even in Nigeria, as liquidity in money markets declined
significantly, following credit rationing in the interbank markets. The tightening of
liquidity in the market and increasing default risk, culminated in the intervention of
central banks in the financial system. In Nigeria, the Central Bank, injected over
N620 billion or approximately $4.1 billion, representing 2.5 per cent of Nigeria‟s
entire 2010 GDP into the banking system to improve the banks' liquidity and keep
them from failing. Between 2008 and 2009, Nigerian banks wrote off loans
equivalent to 66% of their total capital. A majority of these write offs occurred in
the eight banks, which received intervention from the CBN. The write offs
occurred because most of the assets created were relatively illiquid and had
diminished in value.
Managing banking system liquidity involves monitoring and projecting cash flows
needs of banks, to ensure that adequate liquidity is maintained. Maintaining a
balance between short-term assets and short-term liabilities is crucial for the
1
This publication is not a product of vigorous empirical research. It is designed specifically
as an educational material for enlightenment on the monetary policy of the Bank.
Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the
accuracy of the contents of this publication as it does not represent the official views or
position of the Bank on the subject matter.
2
Obiageri C. Ndukwe is an Economist in the Monetary Policy Department, Central Bank of
Nigeria.
1
survival of the banking system. Liquidity is particularly important to banks due to

their high leveraged positions, to compensate for expected and unexpected
fluctuations in the balance sheet.
The financial crisis has clearly shown how liquidity issues can spread and be
transmitted through out an entire financial system. The dire consequences of
insufficient liquidity, make liquidity risk management a key element in a bank‟s
overall risk management structure. The inability of a bank to meet its obligations
upon request may result in a bank run. To reduce the risk of a bank run, banks are
statutory required to maintain a certain proportion of their assets as liquid assets.
A bank can employ various strategies to keep liquidity levels above statutory
requirement, however, these deposit come with a cost. A bank that attracts
significant liquid funds at lower costs has the potential for generating stronger
profits and efficiently delivery its financial intermediation functions to the benefit
of the economy.
This paper examines banking system liquidity, what constitutes liquidity, sources
and use of banking system liquidity, liquidity risk and various liquidity management
systems deployed by the central bank in monitoring and controlling bank
liquidity.
2
SECTION TWO
Conceptual Issues in Banking System Liquidity
2.1 Liquidity
Liquidity can be referred to as a measure of the ability and ease with which
assets can be converted to cash on short notice, or by having access to credit, in
response to meeting cash and collateral obligations at a reasonable cost. It can
also refer to the ability of banks to meet their liabilities, unwind or settle their
positions as they fall due (Basel Committee of Banking supervision). Liquidity is also
defined as the availability of funds, or guarantee that funds will be available
quickly to cover all cash outflow commitments in a timely manner. From these
definitions, it is clear that easily convertible assets are kept in anticipation of
customer demand. An asset is liquid, if it is readily converted to cash without
materially impacting on the price of the asset. The ease of moving or transferring
the asset is also an important factor for an asset to be liquid. If an asset cannot
easily be moved or transferred and the full market value of an asset cannot be
easily realized at short notice, such an asset is said to be illiquid. Examples of
illiquid assets include unsecured loans to bank customers or real estate, while
liquid assets include cash, government treasury bills and debt instruments or
central bank reserves.
On a broad perspective, liquidity can be classified into three categories; namely

central bank liquidity, market liquidity and funding liquidity. On the one hand,
central bank liquidity constitutes deposits of financial institutions held at the
central bank. These deposits are required by the central bank and are often
known as reserve balances. Reserves are held by banks to meet the prudential
guidelines or statutory requirements. On the other hand, market liquidity involves
buying and selling of assets without unduly affecting the assets price. In other
words, an asset‟s market liquidity is the ease at which an asset can be sold
quickly without incurring unacceptable losses. Lastly, funding liquidity describes
the ability to raise cash or its equivalent, quickly either through collaterized loans,
asset sales or by borrowing. A bank, is therefore, liquid if it is able to meet funding
needs as at when the demand arises and if at all times outflow of funds from the
bank are less than or equal to inflows into the bank. Short of this, there will be a
liquidity mix match, which can lead to a crises or a run on the bank.
Maintaining a sufficient level of liquidity in the banking system depends on the

ability of the banking system to daily satisfy both expected and contingent
demand for money, without negatively impacting on daily operations of the
institutions or constituting a systemic risk. Illiquidity arises from assets and liabilities
3
mismatch as well as gaps between receipts and payments. Lack of liquidity can
force a bank to borrow at very high rates, which worsens the already illiquid
position of the bank, and if not effectively managed can result in insolvency.
Liquidity is therefore, a prerequisite for the viability of any financial institution to
meet short term obligations upon request or as at when due.
2.2 Capital and Liquidity Nexus

Capital and liquidity are different but related concepts. Each plays a vital role in
understanding the banking system viability and solvency. Liquidity is a measure of
the ability and ease with which assets can be converted to cash. To remain
viable, a financial institution must be sufficiently liquid to meet its near-term
obligations, such as withdrawals by depositors.
Capital on the other hand is the net worth or equity of a bank. It is the difference
between assets and liabilities and represents a margin to which creditors are
covered upon liquidation of assets. It can be said to act as a buffer to absorb
unexpected losses.
Liquidity requirements and capital requirements impact on different aspect of

banks' balance sheet. While the former is concerned with withdrawal risk on the
liability side of the balance sheet, the later deals with asset-substitution, requiring
a proportion of banks' liabilities as equity.
To remain solvent, the value of assets must exceed liabilities. In recent past
following the event of the financial meltdown, banks that failed or needed
government intervention have been banks with inadequate capital, a lack of
liquidity, or a combination of the two.
2.3 Liquidity - Regulatory Requirement

Banking system liquidity from the perspective of central banking refers to the total
balances of all banks‟ reserve accounts with the central bank. The total volume
of banking system liquidity is greatly influenced by the monetary operations and
monetary targets of the central bank. The process of monetary policy
implementation require the use of policy instruments that serve to stabilize interest
rates at a level that is in tandem with the monetary targets set by the Central
Bank. Stability in monetary aggregates means that the Central bank achieves
equilibrium between demand for and supply of liquidity in the banking system.
The central bank injects liquidity through its open market operations (the
purchase of domestic securities), reverse repo operations or by extending credit
facility.
4
Banking system liquidity is impacted by balance sheet structure and hence cash
flows obligations of banks. Customers withdrawal of deposits are often random
and unpredictable, as a result, the liquidity reserves of individual banks vary and
are not constant, often resulting in surplus or deficit liquidity in the banking system.
Liquidity is surplus in the banking system, when inflow of funds into the system is
only as a result of the monetary operations of the central bank and not in
response to a voluntary demand for liquidity by banks. On the other hand, the
banking system is faced with tight liquidity conditions or a deficit, when the
voluntary demand for liquidity by the banking system needed for complying with
the statutory reserve requirement, or honour current liabilities exceeds the volume
of monetary operations of the Central bank.
Central Banks require deposit money banks (DMBs) to keep a minimum liquidity
ratio that ensures that the banks are able to meet current liabilities and settle
outstanding obligations as they fall due. Liquidity ratio is measured as a ratio of
liquid assets to current liabilities. Liquid assets include cash, short term investment
securities and government bonds while current liabilities on the other hand
include, customer‟s deposits, borrowings etc (see Table 1).
Table 1: Components of Liquidity Ratio Computation - CBN

Liquid Assets Current Liabilities
Cash Total Deposit

Balances held with CBN Cert. of deposits issued
Net balances with banks within Nigeria Net balance held for other banks
Nigerian Treasury Bills Net money at call held for other banks
Nigerian Treasury Certificates Net interbank placements held for other
banks
CBN Registered Certificates Net takings from discount banks
Net Inter-bank Placement with Other Balances held for external offices less
Banks balances held with external offices
Net Money At Call with Other Banks Balances held for external banks less
balances held with external banks
Net Placement with Discount Houses Bankers acceptance
Total Certificate of Deposit
FGN Bonds
Stabilization Securities
Total Liquid Assets Total Current Liabilities
Liquidity Ratio = Total liquid assets /Total Current Liabilities * 100
Source: Central Bank of Nigeria
5
Minimum liquidity ratio as specified by the Central Bank of Nigeria is 30%.

However, a higher liquidity ratio increases the safety margin of banks.
Besides the liquidity ratio, there are other legal reserve requirements that the
Central Bank of Nigeria use in regulating the liquidity in the banking system. The
Central Bank also requires that banks hold a certain percentage of their deposits
as reserve with the Central Bank. The fraction held is called the Cash Reserve
Ratio.
6
SECTION THREE
Sources of Banking System Liquidity
There are different ways and methods banks source for and maintain liquidity.
One way is through asset management while the other is liability management.
Sources of funds include customer‟s depositors, borrowing from the interbank
market, securitization and loan syndication or directly from the central bank.
3.1 Asset Management

The main source of liquidity for a deposit money bank is customer deposits,
whereas bank reserves and loans are its primary assets. Banks also invest in fixed
income securities such as treasury bills which are easily converted to cash and as
such serve as a source of liquidity to the bank. The holding of such assets that
can easily be converted into cash, is known as asset management banking.
3.2 Liability Management

Other options for generating liquidity include interbank borrowing, borrowing from
the central bank and raising additional capital. When a Bank‟s source of funding
is predominantly from borrowing, it is referred to as Liability management. In such
instances, the bank does not generate sufficient funds from customer deposits
and as such, borrows funds from other financial institutions or government. To
remain liquid, the funds borrowed, are often continually rolled over. The interest
rates paid by the bank can rise rapidly if the credit worthiness of the bank
diminishes. This source of liquidity for banks is much riskier than asset management
and can lead to bank failure, if a run on the bank ensues.
3.3 Funding Sources: Assets
3.3.1 Asset Sale

Liquidity can be sourced through the management of banks' asset structure,
either from outright sale of assets, or structured pay-down of assets. Depending
only on asset sale to match the liquidity needs of banks may result in adjustments
in price and credit availability, as assets which are liquid, may sometimes not be
liquidated quickly, easily or profitably. For instance, investment securities such as
treasury bills may be used as collateral for repurchase agreement (thus
unavailable) or impacted negatively by interest rate volatilities (hence may not
be liquidated profitably). However, keeping assets as cash to fulfill future liquidity
needs results in inefficiencies and loss in profitability. A balance between liquidity
and profitability is, therefore necessary. Liquidity management in banks, require a
careful weighing of the return on liquid assets against the higher returns yielded
by assets that are less liquid.
7
3.3.2 Asset Securitization

Asset securitization is a process where banks pool various types of illiquid assets
and transform them into cash or marketable securities. Securitization is an
effective funding means for banks. It allows banks and also non-financial firms to
obtain liquidity from assets which cannot be sold in liquid markets or assets, which
otherwise, would have been carried in their balance sheet till maturity. The
process of asset securitization, is carried out to remove the illiquid assets from the
balance sheet of banks, either through sale or transfer, to a third party. The third
party, called the issuer, raises asset backed securities and sells them to investors
in the public debt market. Returns to the investors are generated from cash flows
received from the assets that were transferred /sold to the third party (issuer of the
debt). Examples of assets that can be securitized include mortgage loans
(commercial and residential), auto loans and credit card receivables.
3.3.3 Loan Portfolio and Loan Commitments

A bank loan portfolio can serve as a source of liquidity. Loans can be sold in the
secondary market or used as collateral for borrowing. Sale of a loan portfolio in
the secondary market frees the bank from interest rate risk as well as provides
liquidity. Loan commitments such as fee –paid letters of credit also represent off
balance sheet source of funding to banks.
3.3.4 Investment Portfolio

Investment portfolio consist of various investments held by a bank. These securities
have varying tenors with different maturity dates, which can be held to maturity
or used as collateral in repurchase agreements. There are various categories of
investment securities and they include; Investments held-to-maturity (HTM),
Investments available-for-sale (AFS), and Investments held for trading. Investments
classified as held to maturity are carried in the bank's books and serve as liquidity
while those that are intended for sale prior to maturity are called Available-for-
sale. Available for sale securities are marked to market daily and provide a
source of income to the bank.
3.4 Funding Sources: Liabilities

An alternative to funding through assets is the use of liabilities.
3.4.1 Deposits
Deposits include the sum of demand deposits, all savings, and time deposits
accounts kept by individual customers. Core deposits are a stable and lower cost
funding sources for banks. Convenience, superior customer service, widespread
ATM networks, and low fee accounts are significant factors in attracting and
retaining customer deposits among banks.
8
3.4.2 Whole Sale and Market Based Funding

Increasing use of liabilities by banks arises from increased competition for core
deposits which are insufficient to meet the funding needs of individual banks.
Consequently, banks turn to whole sale funding to satisfy their funding needs.
Wholesale funding sources include: Central bank funds, public sector funds,
foreign deposits, correspondent banking lines and liabilities of large pension and
mutual funds and other financial intermediaries. Wholesale markets provide
banks with flexibility to manage cash flows as the funds can be structure with
varying number of maturities. Although wholesale funding allows banks quick
access to liquidity, over reliance on such funds is associated with higher levels of
liquidity risk, interest rate risk and credit sensitivity of the fund providers. When a
bank finances long term illiquid assets with short-term wholesale funds, it becomes
vulnerable to runs by its wholesale creditors who may discontinue funding at
maturity of existing contracts.
3.4.3 Public Funds

Liquidity sourced from government agencies and parasatals are referred to as
public sector funding. Funding from the public sector often fluctuate and are
often dependent on the seasonal timing of funds inflow. They are also affected
by general economic conditions, especially during economic contraction that
result in shortfall of revenue, hence the need for the central bank to regulate and
restrict use of public sector funds as part of liquidity of banks.
3.4.4 International Funding Sources

Banking system liquidity is also composed of funds from international markets.
Banks enhance their liquidity position by accessing and maintaining lines of credit
for international trade transactions involving the use of correspondent banks.
3.4.5 Central Bank Funds

Banks can access the Central bank windows or facilities to meet short term
obligations. The Central Bank of Nigeria Standing Lending Facility (SLF), is
available for banks to borrow at a specified interest rate above the Monetary
Policy Rate to meet temporary shortfall in liquidity. The funds, mostly are borrowed
overnight and accessed by banks that need to meet with the statutory daily
liquidity ratio. However, consistent use of Central bank funds can portend a
warning signal to the regulatory authorities of potential distress in a bank.
3.4.6 Interbank Borrowings

Banks borrow in the interbank market money market for over-night, short-term or
unanticipated funding needs, loan creation or deposit withdrawals. The interest
rate at which banks borrow is dependent on the forces of demand and supply
9
and the credit rating. Banks with a lower rating, typically borrow at a significantly
higher interest rate than banks with better credit rating.
Borrowing as a source of liquidity has some risk which includes:

• Secured borrowing often involves pledging of assets of high quality as
collaterals. The use of such assets as collateral excludes them from
the liquid pool and makes them unavailable for unexpected demands
on liquidity.
• It may be increasingly difficult to borrow in an economy experiencing
a contraction. When the economy is not growing, the amount of
liquidity that is created by banks from deposits is limited, and where
available, might be at a very high cost, which may be higher than the
expected returns from the assets (loans) that are carried in banks
books, resulting in a negative spread.
• Changes in market conditions can impair a bank's ability to manage
its funding maturity structure.
• There is also the risk of funding concentrations, diversification risk,
maturity distribution, and risk of interest rate fluctuations, which can
negatively impact on liquidity.
Management of the various risks to funding depends largely on the mix of funding
sources and the banks risk tolerance.
3.4.7 Repurchase Agreements Transactions

Repurchase agreement (Repo) is a form of secured borrowing, where the bank
sells a security to another financial institution and commits to repurchasing the
security at the same price in addition to some interest at a future date. In selling
the security, the bank receives cash, which is used to meet financial obligations.
The repurchase agreement is structured in such a manner that the repayment is
timed with the bank‟s forecast cash flow. The amount borrowed is the full market
value minus a margin called a “haircut”. Repurchase agreements are typically
for overnight funding (overnight repo), but can be structured for longer periods
(term repo). The repo rate is influenced by the quality of the underlying security
used as collateral, the higher the quality and ease of delivery, the lower the
interest rate or repo margin, conversely, the lower the credit quality, the higher
the haircut.
The use of liabilities as a source of liquidity is greatly affected by how sensitive the
institution is to credit risk as well as sensitivity to interest rate volatilities.
10
SECTION FOUR
Liquidity Risk
Liquidity risk is the risk that banks cannot meet their financial obligations as they
fall due. This can lead to a sudden loss of confidence in the financial system and,
potential default. The banking system is susceptible to liquidity risk as banks are
exposed to funding mismatches. .
A Sound liquidity risk management involves prospective analysis or estimate of

future needs of funds, and planning for operational and contingent sources to
fund these needs in the most cost effective manner, for both on and off –
balance sheet activities. Management of operating liquidity involves continual
monitoring of current and expected future needs for funds in the banking system,
and ensuring that avenues exist for banks to access funding when needed. On
the other hand, management of contingent liquidity refers to planning for
uncertainties that may adversely impact on liquidity of banks.
Key factors that increase liquidity risk in the banking system include:
 Poor asset quality,
 Deteriorating assets
 Inadequate liquid assets,
 High cash-flow volatility,
 High or rising funding costs
 Concentrations in funding sources,
 Reliance on funding from credit- and rate-sensitive providers.
External factors include:

 Economic contractions
 Major changes in global financial and economic conditions
 Dislocations in financial markets,
 Poor public confidence,
 Asset price volatilities
4.1 Red Flags to Declining Banking System Liquidity

The recent global financial crises have largely shown how systemic funding
liquidity risk can cripple the financial system. If any lesson is to be learnt from the
crises, it is that the too-big-to-fail syndrome is fallacious, as a number of banks
globally were rescued by liquidity interventions from various governments. It has
become clear that the banking system is highly vulnerable to systemic crises,
which can occur from a combination of several factors culminating in a dry up of
liquidity.
11
It has become increasingly important to be able to assess and identify red flags
that indicate that the banking system is suffering from a liquidity squeeze, and if
unchecked, can lead to financial crises. Such indicators include, high and rising
interest rates, declining level of transactions in the Interbank Market, Declining
Closing balances of Deposit Money Banks, increased access to the CBN standing
lending facility and other discount windows.
4.1.1 High and Rising Level of Interest Rates

Shocks to economic and market conditions are sometimes unpredictable, and
the impact of these shocks often influences the ability of banks to attract or retain
low cost funding. When low cost funding increasingly becomes difficult, it implies
that banks may take on wholesale funding with higher interest rates to be able to
access more liquidity. Higher interest rates could emanate from higher term
deposit rates requested by high net worth individuals or large institutions. When
interest rates are rising and significantly higher than the bench mark interest rate
(Monetary Policy Rate, MPR, in Nigeria), it could mean that the banking industry is
experiencing a deficit in liquidity. Interbank interest rates typically rise in response
to higher demand for more funding. The higher the demand for supply of funds,
the higher the interest rates rise relative to the policy rate and large mismatches
between maturing liabilities and assets exposes banks to volatile upswings interest
rates risk.
4.1.2 Declining Deposit Money Banks’ Closing Balances

Banks that depend on volatile liabilities - such as whole sale funds to finance
interest bearing assets are exposed to the credit sensitivity of the fund providers,
who may suddenly reduce or withdraw funds. Predominant funding of interest
bearing assets that are highly illiquid, or of low credit quality, with unpredictable
cash flows increases the risk of default which impacts on the liquidity of banks.
Banks face the risk that a slowdown in cash flow from interest and principal
repayment from interest bearing assets will occur at the same times as when
liabilities mature, and are not rolled over but exit the bank. A condition as
described above can reduce the closing balance of DMBs with the central bank.
A persistent decline in the closing balances of DMBs with or without rising interest
rates is indicative of a liquidity squeeze or tight monetary conditions in the
banking system.
4.1.3 Increased Demand for Secured Lending in the Interbank Market

Generally, secured funding are preferred to unsecured funding in the interbank
market, as banks look to the pledged assets to ensure repayment. Secured
lending ensures that the creditor is not exposed to the performance of the
borrowing counterparty. However, changes in the counterparty's credit risk rating
of a bank can influence the collateral and interest rates demanded of a bank.
12
Therefore, liquidity in the banking system is significantly impacted by credit risk

exposure. Credit risk exposure of a bank results in changes in counterparty
collateral requirements for secured funding. A borrowing bank with a high credit
risk exposure, may have to increase the quality of assets pledged as collateral in
order to access funding. This increasing high collateral requirements can impact
on the number of transactions and cost of funding in the interbank market, as
more liquid banks require more security for their funds from the liquidity deficient
banks. Reliance on funding from the interbank market can therefore, contribute
to an increase in the liquidity risk profile of banks, and heightened systemic
liquidity risk.
Unexpected disruptions in global and domestic funding sources can impact on

trading, resulting in adjustments in a market‟s risk pricing. Increased activity in
secured transactions in the market indicates the banking system‟s aversion to
unsecured lending, and are indications of tight monetary conditions in the
market. Further, when the banks predominantly seek for repurchase agreements
(Repo) as against reverse repo transactions, it is indicative of drain on liquidity in
the system.
4.1.4 Increased Access to Central Bank Standing Lending Facility

Central Banks function as lenders of last resort to banks. However, increased
patronage of the discount windows portends that banks may be experiencing a
drain on liquidity or even worse. The rate at which the Central bank of Nigeria
lends to banks is called the standing Lending Facility (SLF), which is an interest rate
slightly above the monetary policy rate. Typically, the interest rate charged on
the SLF is lower than the interbank borrowing rates; however, the SLF should not
be accessed as a primary source of funding for banks rather a last resort.
Accessing the discount window may be perceived as a sign of weakness and
signifies tight liquidity conditions in the banking system. Increased amount of SLF
requested by banks is a warning signal, indicating distress in the banking system.
13
14
SECTION FIVE
Management of Banking System Liquidity in Nigeria

Effective management of banking system liquidity involves careful examination
and supervision from the monetary authorities. The Central Bank of Nigeria is
responsible for the health and financial stability of the banking industry, thus,
among other functions, it regularly examines the books of banks to ensure that
they are at all times liquid and solvent. The Nigerian Deposit Insurance
Corporation (NDIC) insures depositor‟s funds and guarantees the settlement of
insured funds when a bank defaults or fails.
In order to improve macroeconomic stability, the CBN has over the years
managed excess liquidity in the banking system. Some of the measures/policies
used Post SAP include:
 Reducing the maximum ceiling on credit growth permissible for banks;
 Recall of the special deposits requirements against outstanding external
payment arrears to CBN from banks
 Abolishing the use of foreign guarantees/currency deposits as collaterals
for Naira loans and
 Withdrawal of public sector deposits from banks to the CBN.
5.1 Monetary Policy Response to Deficit Liquidity in the Banking System

(The wake of the global financial crises 2008 - 2011)
The conduct of monetary policy in Nigeria after the global financial meltdown
was largely influenced by the global financial crises. The period beginning 2007
in the United States and spreading to other countries in the developed and
developing countries, was characterized by increasing non-performing loans,
falling external reserves, pressures on the exchange rate, large capital outflows,
collapse of the stock market and a huge liquidity crises in the banking system. As
a result of the crises in the financial system, the CBN adopted a monetary policy
stance to ease the liquidity shortage in the banking system. Measures taken to
improve banking system liquidity include:
• Reduction of aggressive liquidity mop-up

• Progressive reduction in the benchmark interest rate reduction of
monetary policy rate (MPR)
• Reduction of cash reserve requirement (CRR)
• Reduction of liquidity ratio (LR)
• Commencement of Expanded Discount Window (EDW) to increase
Deposit money banks' (DMB) access to funding facilities from the CBN.
15
 Introduction of CBN Guarantee of interbank transactions to boost

confidence and improve interbank trading among DMBs
 Reduction of Net Open Position (NOP) limit of DMBs
• Injection of N620 billion as tier 2 capital in eight (8) troubled banks
5.2 Monetary Policy Response to Excess Liquidity in the Banking System

(2010 - 2014)
The process of stabilizing the financial sector after the financial crises resulted in
the injection of liquidity in the Banking system. Further, the cleaning of banks'
balance sheet following AMCON intervention led to the return of excess liquidity
in the banking system, which among other uses by banks and in conjunction with
fiscal expansion, increased pressure on inflation, exchange rate and depleted
the reserves. Consequently, the CBN changed its monetary policy stance from
accommodating to tightening to curb the surge of liquidity in the banking system.
Some of the control measures/instruments include:
• Targeted liquidity management using active Open Market Operations

• Progressive increase in the monetary policy rate (MPR) from 6 per cent to
13 per cent
• Progressive raising of the Cash Reserve Requirement (CRR) from 1 per cent
to 20 per cent for private sector and 75 per cent for public sector.
• Increasing the liquidity ratio (LR) from 25 per cent to 30 per cent
• Reduction of NOP of banks from 3 percent to 1 per cent
• Moving the mid-point of the foreign exchange band from ₦150/US$1 +/-3
per cent to ₦168/US$1 +/-5 per cent
5.3 Policy Instruments Used by the Central Bank in Controlling Banking

System Liquidity
A number of monetary policy tools/instruments are used by central banks in
monitoring and controlling banking system liquidity, some of which are: cash
reserve ratio, liquidity ratio, loan to deposit ratio, monetary policy rate, symmetric
corridor around the MPR, various foreign exchange regulations/instruments such
Net Open Position and Introduction of rDAS, and introduction of Treasury Single
Account (Federal Ministry of Finance).
5.3.1 Cash Reserve Ratio

Banking system liquidity is influenced by the Cash Reserve ratio (CRR). Cash
Reserve ratio is a specified minimum fraction of customer deposits required of
deposit money banks to be held as reserves either in cash or with the central
bank. The CRR is an effective tool for controlling liquidity in the banking system
and by extension money supply in the economy. During periods of excess
16
liquidity, the CRR is raised to sterilize a higher fraction of funds as reserves with the
central bank. The impact is a direct reduction in the amount of liquidity in the
banking system as banks increase the proportion of funds held as reserves. The
CRR is used as a monetary policy tool in controlling the supply of money in the
economy and influencing the level of interest rates. It can also be effective as a
tool to regulate the foreign exchange market in response to a slide in the
domestic currency. By reducing the liquidity in the banking system, it is expected
that banks will have less funds available to lend and thus reduce speculation and
buying pressures in the foreign exchange market.
5.3.2 Liquidity Ratio

Banks are required to hold a statutory fraction of current liabilities as liquid assets.
This is to ensure that the banking system remain liquid, and at all times are able to
meet payments, obligations and demands on customer deposits as at when due.
The liquidity ratio is an indicator of the liquidity in the banking system and is used
by the central bank to monitor and control the supply of money in the economy.
5.3.3 Loan to Deposit Ratio

Loans that banks make available to customers are funded by customer deposits
and other sources. When the loan to deposit ratio is too low, it means banks are
not creating sufficient interest bearing assets and may not be earning enough to
remain in business or may point to some other fundamental macro-economic
conditions that need addressing. On the other hand, when the loan to deposit
ratio is too high, it signifies that banks are issuing more of their deposits in interest
bearing loans and may not have sufficient liquidity to meet any unexpected
demands on funding. A banking system with a very high loan to deposit ratio may
be exposed to significant liquidity risk. For instance, during an economic
downturn followed by significant loss in business and revenue of firms, the rate of
non-performing will rise significantly, when this happens, the banking system faces
a liquidity risk and may require intervention from the central bank to prevent a
systemic crises.
5.3.4 Foreign Currency Trading Position

Reducing the amount of foreign currency trading position of banks can be
effective in controlling excess liquidity in the banking system. The Net open
position of a bank is a percentage of shareholders‟ funds that banks are allowed
to use to trade in foreign exchange in the interbank market. The effect of a
reduction in the trading position is a reduction on the amount of income that
banks can generate from trading foreign exchange. The reverse (i.e increase in
NOP) will have the opposite effect on banking system liquidity.
17
5.3.5 rDAS Introduction

Retail Dutch Auction System was introduced by the central bank to reduce the
pressure on the foreign exchange and tighten loopholes arising from speculative
demand. rDAS involves actual customer bid for payment of imports. The
transmission mechanism of rDAS on banking system liquidity is through the
reduction of the spread that banks make from speculative purchase of foreign
exchange via the system of wholesale dutch auction.
5.3.6 Implementation of TSA

The implementation of the Treasury single account (TSA) can be used as a tool to
curb excess banking system liquidity. By pooling all government funds into a
single account, banks that rely heavily on public sector funds will be exposed to
liquidity risk. Banking system liquidity will be impacted by the amount of public
sector funds that will be pooled out of the banking system.
18
SECTION SIX
Conclusion
Banking system liquidity is imperative for macroeconomic sustainability given the
role that the banking system plays in financial intermediation. Banks use liquid
assets from deposits and other sources to fund illiquid assets that boost economic
activities. However, the process of creating the needed liquidity is associated
with some level of funding risk and hence systemic liquidity risk. Such liquidity risk
are often triggered when there are perceived concerns of insolvency caused by
poor asset quality. Liquidity risk can be mitigated by the implementation of a
consistent set of policies and procedures used for identifying, measuring, and
controlling liquidity risk exposures. It is important that liquidity risk thresholds should
be specific and in line with the liquidity risk profile of specific banks. Risk thresholds
should indicate limits on sources and uses of funds, funding mismatches and
funding concentrations, while banking system liquidity can be improved by funds
diversification.
19
20
Glossary of Terms
Bank Runs: A bank run is increasingly and unsustainable demand for cash by
customers of a bank. Even when a rumour has no base, it can lead to a run on a
Bank, causing a liquidity crises and bank failure.
Benchmark Interest Rate: A standard interest rate against which other interest
rates can be measured.
Shock: An unexpected or unpredictable event that affects real variables in an

economy, either positively or negatively.
Risk Management: The process of identification, analysis, mitigation and control

of uncertainty in investment decision-making.
Solvency: The ability of an institution to pay all its debts or long term obligations
Non Performing Loans: Loans that are in default or when the borrowing are
neither paying the interest or principal repayment as stipulated by the loan
agreement.
Hair Cut: The difference between the market value of a security and its collateral
value. It is a percentage taken off the market value of an asset that is being used
as collateral. The greater the percentage of the haircut, the higher the perceived
risk associated with the loan. Conversely, the lower the haircut, the safer the loan
is for a lender.
Market Risk: Refers to the risk of losses an investor can face in the event of
fluctuations in market prices.
Sensitivity: Accounts for all factors that positively or negatively impact the value
of a given instrument or asset
Held-to-maturity: Classification of investment assets purchased and held till

maturity
Mark to Market: A measure that shows the fair value of an asset or liability. It is
indicative of the institutions current financial position
Available for Sale: Classification of assets purchase for trading purposes.
21
22
Bibliography
Allen F. and Carletti E. (2006). “Credit risk transfer and contagion”, Journal of
Monetary Economics 53, 2006, 89-111
Allen N. Berger and Christa H. S. Bouwman. (2007). “Bank Liquidity Creation”
Federal Reserve bank August 2007
Central Bank of Nigeria publications, various issues @www.cbn.gov.ng
Christa H. S. Bouwman, (2013). " Liquidity: How Banks Create It and How It Should
Be Regulated" Oxford Handbook of Banking, October 2013
Diamond D. W., and Raghuram G. Rajan (2000). “A theory of bank capital”
Journal of Finance 55: 2431-2465.
Diamond, D. W., and R. G. Rajan (2001). „Liquidity risk, liquidity creation, and
financial fragility: A theory of banking,‟ Journal of Political Economy 109:
287–327.
Distinguin I. C. Roulet, and A. Tarazi (2013). „Bank regulatory capital and liquidity:
Evidence from US and European publicly traded banks,‟ Journal of
Banking and Finance 37: 3295-3317.
Greenbaum S. and Thakor A. (1987). “Bank Funding Modes: Securitization versus
Deposits”. Journal of Banking and Finance, 11, 1987, 379-401.
Hänsel D. N. and Krahnen J. P. (2007). “Does credit securitization reduce bank
risk? Evidence from the European CDO market”, Mimeo, Goethe-
University, Frankfurt, 2007.
Karel B. and Jaroslava D. (2012). "Banking system liquidity absorption and
monetary base backing in the context of exchange rate policy in the
Czech Republic, Poland and Hungary". Post-Communist Economies Vol.
24, No. 2, June 2012, 257–275.
Pennacchi G. (2006). Deposit insurance, bank regulation, and financial system
risks, Journal of Monetary Economics 53: 1-30.
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Understanding Monetary Policy Series No 34

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Understanding Monetary Policy Series No 34

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CENTRAL BANK OF NIGERIA

BANKING SYSTEM LIQUIDITY

Aims and Scope

Subscription and Copyright

§Ensure monetary and price stability

To Facilitate the Conceptualization and Design of

To be Efficient and Effective in Promoting the

To Provide a Dynamic Evidence-based

Section One: Introduction .. .. .. .. .. .. 1

Section Two: Conceptual Issues in Banking System Liquidity

Section Three: Sources of Banking System Liquidity .. .. .. 7

Section Four: Liquidity Risk .. .. .. .. .. .. 11

Section Five: Management of Banking System Liqudity in Nigeria 15

Section Six: Conclusion .. .. .. .. .. .. 19

BANKING SYSTEM LIQUIDITY1

survival of the banking system. Liquidity is particularly important to banks due to

On a broad perspective, liquidity can be classified into three categories; namely

Maintaining a sufficient level of liquidity in the banking system depends on the

2.2 Capital and Liquidity Nexus

Liquidity requirements and capital requirements impact on different aspect of

2.3 Liquidity - Regulatory Requirement

Table 1: Components of Liquidity Ratio Computation - CBN

Cash Total Deposit

Minimum liquidity ratio as specified by the Central Bank of Nigeria is 30%.

3.1 Asset Management

3.2 Liability Management

3.3 Funding Sources: Assets

3.3.1 Asset Sale

3.3.2 Asset Securitization

3.3.3 Loan Portfolio and Loan Commitments

3.3.4 Investment Portfolio

3.4 Funding Sources: Liabilities

3.4.2 Whole Sale and Market Based Funding

3.4.3 Public Funds

3.4.4 International Funding Sources

3.4.5 Central Bank Funds

3.4.6 Interbank Borrowings

Borrowing as a source of liquidity has some risk which includes:

3.4.7 Repurchase Agreements Transactions

A Sound liquidity risk management involves prospective analysis or estimate of

External factors include:

4.1 Red Flags to Declining Banking System Liquidity

4.1.1 High and Rising Level of Interest Rates

4.1.2 Declining Deposit Money Banks’ Closing Balances

4.1.3 Increased Demand for Secured Lending in the Interbank Market

Therefore, liquidity in the banking system is significantly impacted by credit risk

Unexpected disruptions in global and domestic funding sources can impact on

4.1.4 Increased Access to Central Bank Standing Lending Facility

Management of Banking System Liquidity in Nigeria

5.1 Monetary Policy Response to Deficit Liquidity in the Banking System

• Reduction of aggressive liquidity mop-up

 Introduction of CBN Guarantee of interbank transactions to boost

5.2 Monetary Policy Response to Excess Liquidity in the Banking System

• Targeted liquidity management using active Open Market Operations

5.3 Policy Instruments Used by the Central Bank in Controlling Banking

5.3.1 Cash Reserve Ratio

5.3.2 Liquidity Ratio

5.3.3 Loan to Deposit Ratio

5.3.4 Foreign Currency Trading Position

5.3.5 rDAS Introduction

5.3.6 Implementation of TSA

Shock: An unexpected or unpredictable event that affects real variables in an

Risk Management: The process of identification, analysis, mitigation and control

Held-to-maturity: Classification of investment assets purchased and held till