In the banking sense, this is a bank’s exposure to the possibility of becoming insolvent. This is a situation in which the bank’s creditors and/or regulators compel it to cease trading until it is recapitalised, taken over or wound up. In other words it is the risk of ultimate financial failure through chronic inability to meet obligations. Solvency is the ability to meet external liabilities in full through realising assets at current value as ascertained by a value calculation. This solvency is threatened by the possibility of events that necessitate the writing down of the value of some assets.
Solvency risk is mainly avoidable through maintaining a level of equity. These shareholders fund are preferable as a buffer for insolvency since they are they are available to be written down in a going concern; rather than writing down external liabilities, mainly public deposits. Adequate capital is thus the ultimate safeguard for bank solvency as a third line defence after profits and provisions (Balla and McKenna, 2009, p.392)
Theoretically however it is still possible to safeguard without any capital as long as it is possible to absorb losses or expenses with currently undistributed profits and provisions. This would however be imprudent and impractical since it leaves no safety margin for the unexpected.
This is the risk of a bank being unable to meet repayments, withdrawals and other commitments as they fall due. It defines the potential for running short of cash in hand to settle external commitments such as debts. It can also be defined as the current and probable threat to earnings or capital as caused by incapacity to meet these commitments.
High liquidity risk is characterised by: funds source and liability structure indicate difficulty in long-term and cost-effective liquidity; concentration of fund sources with a few providers, or those with common investment outlook and/ or economic influence; increase of liquidity requirements countered with a decline in sources of market alternatives at reasonable terms; little capacity to augment liquidity through asset sale or securitisation; a material portion of wholesale funds containing embedded options; a liquidity profile that makes it vulnerable to funding difficulties in the event of adverse material change; lack of support from mother company; and potential exposure to loss of earnings on capital caused by high liability costs or unplanned asset reduction.
This defines the risk that a lender will lose his investment in the event that the borrower is not able to pay him in full; even if all the debtor’s assets are liquidated. It is also known as counter-party risk or default risk.
Solvency risk vs. Liquidity risk
Ratnovoski (2007) asserts that liquidity risk is related to solvency risk in some ways, whereby both are crystallised in an ability to meet financial obligations in full. On the other hand illiquidity is temporary whereas insolvency is permanent. Insolvency in a fully capitalised bank is the direct result of huge losses while illiquidity is not necessarily related with losses or write-downs, resulting instead from incoming and outgoing cash flow relationships. Notably though, failure to arrest liquidity risk can rapidly progress from a temporary to permanent problem.
Credit risk relationship with; solvency risk and liquidity risk
Liquidity risk is an obverse of credit risk. A banks liquidity problem would make it unable to pay a creditor which becomes the lender’s credit risk. Another perspective is that cash flow problems stemming from default may affect the ability of the bank to meet its obligations as they fall due. (Ratnovoski, 2007, p. 5)
A banks credit is directly related to its solvency risk. Default risk implies that debtors as an asset are down-written. This affects the banks ability to service external liabilities which is solvency risk.
Also known as pro-cyclicality, it is a tool that assists banks in early detection of credit losses and taking steps to cover the risk. Pro-cyclicality is concerned with bank lending patterns in boom-recession transitions. The pressure exerted on bank capital in a recession; alluded to the fact that specific provisions and write- offs if not absorbed in earnings are bound to reduce bank capital; could lead to cutbacks in bank lending during this period.(Mann and Michael 2001,p.130)
In this respect dynamic provisioning is a macro-prudential tool that is used to boost bank soundness while mitigating the effects of the pro-cyclical tendencies. The early detection of credit losses in bank portfolios and their coverage thereof as mentioned above allow the creation of a buffer in lending booms that is used to handle stress in recessions.
This contributes to the stability and resilience of individual banks; and more importantly that of the banking system as a whole. Pro-cyclicality is evidenced by the admittance by banking supervisors’ world over that bank lending mistakes are more pervasive in upturns. This attributed to over-confidence by both lenders and borrowers in lending projects. The implicit lower lending standards degenerate into conservative and tight lending standards in the ensuing recessions. This turn of events results in a credit crunch, in turn adversely affecting the economy.
There exists empirical evidence of looser credit standards during expansions; and also of a relatively direct relationship between credit growth and credit risk. This implies a sporadic increase in loan portfolios that is linked to non-performing loan ratios later on. It is reported that loans granted during booms have higher default rates than those granted in recessions.
Naturally the tool chosen for dynamic provisioning is the accounting practice of creating provisions. It entails proper identification of credit risks and losses along the lending cycle thus enhancing the stability of each bank and the entire banking system. The mechanism works such that loan loss provisions made in upturn to depict increase in credit risk allow the system to deal with the potential damage that lies in the lending cycle. This minimises the effect on the real economy. ‘Dynamic provisions’ has been coined to describe this loan loss; also statistical or countercyclical loan loss provisions. These deserve attention from both regulators and supervisors in a move to guarantee financial stability at whatever stage of the cycle (Saurina, 2009, p.4-5).
Managing liquidity risk
Liquidity is the ability of a bank to build and maintain sufficient assets and meet commitments. The y settlement of these obligations should preclude incurring unacceptable losses; liquidity is a basic responsibility for banks that encompasses transformation of short-term deposits into maturity enabling banks to service their cash flow obligations these obligations tend to be uncertain due to the effect of external events and agent behaviour (Guglielmo, 2008, p.3).
It is thus the bank’s prime responsibility to soundly manage its liquidity risk. This entails the creation of a robust liquidity risk management framework to sustain sufficient liquidity whose most basic feature is a buffer of un-encumbered, high-quality liquid assets. These are to bear with stress events of a limit-less range including the loss of funding sources. An assessment of the liquidity management framework and the liquidity position is the first and basic step. Prompt response to the assessment should thence be instituted in the lacking parts in a bid to protect depositors and mitigate potential damage to the entire financial system (Cade, 1999, p. 5).
The Basel Committee on Banking Supervision in its second work on recommendations in banking laws and regulations shows that the form of a range of tools as proposed are replicated by the ultimate liquidity risk management framework. The committee’s goal is to foster understanding on top supervisory issues. At a national level the committee has a task to seek trade information on national supervision issues and in the process approaches and techniques to goal attainment. Mostly the committee’s understanding of these issues is used to develop guidelines and supervisory checks and balances in pertinent areas. Through this it has a good history for its international guidelines oh how to be afloat with enough capital, the main driving principles of viable banking supervision and the ‘concordat of cross border banking supervision.
These principles range from: governance of liquidity risk management; to measurement and management of liquidity risk; to public disclosure to; the supervisory and regulatory role (BCBS, 2008, p.7).
Governance of Liquidity risk management
The main tenets of governance dictate to banks that they have to instil a liquidity risk tolerance that matches its business strategy and its part in the financial system. Secondly senior management should put in place a system that back the risk levels in ensuring the bank maintains enough liquidity. The senior management on a regular and ongoing basis is to relook on information on the banks liquidity mostly in view of the board of directors’ approval of thee system on annual basis.
Measurement and management of credit risk
It is a way by which you come up with a process aimed at measurement, identification, control and monitoring of liquidity risk. Constant and proactive attention to liquidity risk vulnerabilities and funding requirements is a must; covering the entire organisational structure while minding the regulatory and operational implications as to the transferability of liquidity. The bank is also to establish funding plan that encompasses the diversity in the fund source and type. An ongoing presence in the select funding avenue is to be maintained coupled with building of formidable relationships with funders. This accomplishes efficient diversification of funding sources (Duffie and Singleton2003, p. 1).
The bank should also regularly evaluate its ability to raise funds abruptly from each of its sources. The bank is also to actively manage its day to day liquidity positions and risks to make payments and settle obligations in time; assessment with normal and stress situation variables considered. This is meant to assist in the smooth functioning of settlement systems. Some important aspects about collateral; for instance its location and case scenario timely mobilisation; should be assessed.
There exists a variety of institution-specific and market wide stress situations that affect the sources of potential liquidity strain. These should be regularly analysed to ensure that current vulnerabilities match the established bank tolerance levels. A formal Contingency Funding Plan (CFP) should be established. This plan details processes and strategies that address probable liquidity shortfalls in cases of emergency. Policies to manage a range of stress situations and clear lines of responsibility are some of the required qualities of the CFP; in addition to regular testing and updating.
To have insurance for a range of liquidity stress situations, the banks are supposed to maintain a cushion of unencumbered high quality liquid assets. Legal, regulatory or operational impediments should be diagnosed and dispensed with.
The bank is to make a public statement of information on a regular basis. This is meant to inspire market decision makers on the soundness of its liquidity risk management system.
The role of supervisors
Supervisors are to regularly carry out assessments of a bank’s overall liquidity risk management systems and liquidity status. This is so as to determine whether the bank is adequately covered with respect to liquidity stress.
On top of their regular assessment of the liquidity risk assessment process the supervisor is to check on a range of reports and market information. In the process it will inspire remedial action which will be punctual and effective by a bank in trying to address shortcomings in the liquidity management which is also a supervisor’s role. Finally the supervisors should keep in touch with other supervisors and regulatory authorities; for instance central banks; locally and internationally resulting in effective cooperation in the supervision and oversight of liquidity risk management. Communication based on frequency and information sharing is to be underscored.
Liquidity problems are typically low frequency but potentially high impact events, and the board of directors and senior management of a bank may pay more attention to other, higher frequency risks or may limit a bank’s liquidity risk mitigation due to competitive considerations. In addition, an expectation that central banks will provide liquidity support, alongside the guarantees to depositors provided by deposit insurance, could diminish the incentives of the bank to manage its liquidity as conservatively as it should. This increases the responsibility of supervisors to ensure that a bank does not lower its standard of liquidity risk management and adopt a less robust liquidity risk management framework as a result. Drawing on their experience and knowledge of a range of institutions in their jurisdictions, supervisors should assess whether each bank maintains sufficient liquidity and should take supervisory action if a bank is not holding a level sufficient to enable it to survive a period of severe liquidity stress. A bank should use appropriately conservative assumptions about the marketability of assets and its access to funding, both secured and unsecured, during periods of stress. Moreover, a bank should not allow competitive pressures to compromise the integrity of its liquidity risk management, control functions, limit systems and liquidity cushion.
In this respect managing liquidity is an important role that not only touches on various areas of management and banking regulation; but also on the entire economy since banks plays a pivotal role in the financial and economic aspects of states and the globe at large. The above principles should therefore be followed enthusiastically and be faulted for over-emphasis rather than under application. Emphasis on major responsibilities is to be outlined with the involvement of the management, board of governors, supervisory authorities; both locally and globally.
Balla, E & McKenna, A, 2009. Dynamic provisioning: A countercyclical tool for loan loss reserves. Web.
Basel Committee on Banking Supervision, 2008. Principles for Sound Liquidity Risk Management and supervision. Web.
Cade, E, 1999. Managing Banking Risks, Reducing Uncertainty To Improve Bank Management and Supervision. Bank for International Settlements. Perfomance. Chicago, Fitzroy Dearbon, Publishers Chicago and London. Public Policy for the Private Sector, Note Number 7, July, The World Bank.
Duffie, D& Singleton, J, K, 2003. Credit Risk: Pricing, Measurement and Management. Web.
Guglielmo, R, M, 2008. Managing liquidity risk. Web.
Mann, F & Michael, I, 2002. Dynamic provisioning: Issues and application. Web.
Ratnovski, L, 2007. Liquidity and Transparency in Band Risk Management. Web.
Saurina, J, 2009. Dynamic Provisioning: The experience of Spain, Crisis Response. Web.