As central banks continue to struggle with taming the stubborn inflation, there are two plausible near term scenarios for banks, credit unions and other institutions holding interest bearing assets and liabilities:
- Disinflation: Disinflation means slowing positive inflation rate, is a negative inflation rate as the U.S. experienced at the end of the Global Financial Crisis in 2009
- Stagflation: A portmanteau formed from “stagnation” and “inflation”, stagflation is an economic hair-raiser which drives prices up but purchasing power down
As access to capital becomes scarce, careful liquidity planning is required to consider the above scenarios and their permutations. This article outlines key management actions to prevent a high severity liquidity event.
Developing early warning signals:
Measuring Funding Liquidity Risk:
Utilizing tools, e.g., core banking system, for
For medium and long term liquidity management, i.e.,
- Liquidity based gap analysis due to contractual and expected cash-flow in total and in each currency. Even though demand depositors can withdraw their funds immediately, in normal circumstances they do not. Develop and segment demand deposits into core, volatile and rate sensitive cohorts, giving the dollar duration of deposits. On average core demand deposits stay at banks for quite long periods - often two years or more. The second step should be the development of the cumulative gap that is the gap of the previous period + actual gap. Next step, develop a funding matrix based on planned transactions in total and in each currency. The bank should be able to forecast future cash flow of assets, liabilities and off-balance sheet. This should help ALCO/Liquidity Managers decide liquidity dependence on depositors, financial institutions, hedging of investments by equity, hedging loans by deposits, liquidity vulnerability and so on.
- With rising market rates, associated liquidity costs also rise. Banks need to carefully examine the degeneration of repricing/maturity mismatch risk into basis risk.
- The cost of liquidity is the additional charge assuming maturity-matched refinancing (i.e. the cost of liquidity depends on the bank’s specific repricing risk). The liquidity risk curve could be the difference between the yield curve of an institution’s financing possibilities and the most liquid swap yield curve. Liquidity costs are premiums the bank has to pay depending on its credit ratings. These are costs that must be charged to customers in the financing.
- Contingency planning using scenario analysis, stress test and limit testing that supplements liquidity risk with several assumptions, resulting in an indexed version of plausible survival horizons. Some firms define states of a crisis and define appropriate measures to mitigate a crisis.
The banks should also have in place an action plan for firm specific and market-related liquidity events. An institution's contingency plans should take into consideration the need to obtain replacement funding, and specify the possible alternative funding sources.