LIQUIDITY management has become a hot topic in the financial sector as institutions struggle to manage funding amid market pressures. Liquidity shortages have recently made the headlines, signalling trouble for banks and non-bank financial institutions. Rising interest rates, economic uncertainty and structural issues within the financial system have shifted the liquidity landscape, demanding a fresh look into how institutions manage their liquidity needs. In the current financial landscape, treasurers grapple with the complexities introduced by persistent high interest rates, which require a renewed focus on liquidity management, particularly intra-day liquidity, as the cost of maintaining sufficient levels becomes increasingly significant.
At the heart of liquidity management lies the ability to ensure enough money available to meet the demands of depositors and borrowers, without having too much cash sitting idle. To address the liquidity pressure, institutions must hold adequate high-quality liquid assets and maintain access to borrowing facilities. This balancing act has become increasingly difficult, especially with the changing dynamics in the economy and monetary policy.
Liquidity risk can be divided into two types: funding liquidity risk, which is the inability to obtain necessary funding at a reasonable cost, and asset liquidity risk, which is the inability to liquidate assets at an acceptable price. Institutions must understand their liquidity flows to manage funding needs effectively. A key aspect of liquidity management is distinguishing between operational and non-operational funds, enabling the optimisation of cash availability without holding excess funds that could be used for lending.
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Roots of liquidity crisis
CONTROLLABLE and internal liquidity risks encompass several factors within an institution鈥檚 management. Bucket-wise asset-liability mismatches occur when there are timing differences between cash inflows and outflows, potentially causing funding gaps. Deposit concentration risk arises from reliance on a small number of large depositors, increasing vulnerability to withdrawals. Hence, an undiversified funding basket limits flexibility in raising funds, heightening liquidity risk. Additionally, rising non-performing loans because of inadequate credit risk management practices can strain liquidity as the flow of expected repayments diminishes.
Liquidity in the banking sector in Bangladesh is exposed to various exogenous and uncontrollable risks that significantly affect financial stability and operational effectiveness. For more than two years, the banking sector has faced a liquidity crunch, particularly impacting some Islamic banks. The contributing factors include panic withdrawal, high dollar values, inflation, a poor debt repayment culture, frequent loan concessions and increased government borrowing at high interest rates.
A significant cause of the shortage is the central bank鈥檚 efforts to control inflation by reducing the money supply, leading to multiple policy rate increases, with the repo rate recently reaching 9.5 per cent. Many banks have turned to the central bank and the call money market, borrowing at rising rates, which has forced them to offer high-interest deposits, further increasing the operational cost.
The liquidity crunch has also been exacerbated by the central bank鈥檚 sale of foreign exchange reserves to stabilise the taka against the dollar, draining liquidity from the system. A lack of public confidence in the banking sector has led people to hold onto cash, with about Tk 2,92,000 crore circulating outside the banking system as of August 2024. This negative sentiment has caused bank deposits to decline, reaching an 18-month low growth rate of 7.02 per cent.
Additionally, business loans are often not repaid on time, with borrowers having received various benefits like moratorium because of the Covid outbreak and the Ukraine-Russia war. Loan scams and money illicit capital flows have further stopped some banks from maintaining the required cash-to-reserve ratio. Regulatory risks arise from frequent changes in banking regulations that affect operational practices and capital requirements, complicating liquidity management. The interest rate cap of 6 per cent for deposits and 9 per cent for loans was limiting banks鈥� responses to inflation. After the withdrawal of cap, there is room for more flexible lending rates, which can help banks to manage liquidity and to enhance financial stability amid rising global interest rates.
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Effective liquidity management
TO STRENGTHEN liquidity management, institutions should implement risk-based treasury management by identifying specific financial and reputational risks and taking necessary measures to mitigate them. It is essential to ensure the availability of at least three months of rolling cash flow forecasts while identifying bucket-wise asset-liability mismatches to minimize gaps.
Maintaining a robust liquidity buffer requires effective treasury management and the capability to meet debt obligations within a rolling 30-day period. Assets should be securely held in banks or government securities to provide for safety and accessibility. The aim should be to achieve a liquidity ratio well above the regulatory requirement. Managing non-performing loans is crucial, with a target of keeping the non-performing loan ratio as minimum as possible. Institutions should proactively manage asset liability risks by monitoring key ratios and their trigger points, emphasising core values of 鈥榯imeliness鈥�, 鈥榓ccuracy鈥� and 鈥榚fficiency鈥�.
To diversify funding sources, institutions should continue embracing digital deposit services, aiming at connecting depositors through a digital platform. Active management of four core areas is necessary to mitigate liquidity risks. Monitoring key macroeconomic indicators such as the current account balance, financial account balance, the opening of letters of credit versus settlement ratio, advance-deposit ratio, yield on government securities, foreign currency position, policy rate movement, inflation and market interest rates 鈥� will guide the understanding of market directions.
Addressing funding liquidity risk involves estimating cash flow from assets and liabilities to identify potential vulnerabilities. Effective mitigation strategies should be developed by understanding the sources of liquidity pressures, such as rising borrowing costs and non-performing loans. Enhancing cash flow forecasting capabilities will help predict funding needs, while diversifying funding sources will minimize deposit concentration.
For liquidity stress testing, financial institutions should assess their ability to meet obligations during challenging periods. Insights from these assessments will inform contingency planning, strategic development, and the definition of its risk appetite.
A key challenge in liquidity management is ensuring sufficient cash for daily operation, especially with potential tightening on the money market. Implementing advanced treasury management systems will enhance the efficiency and accuracy of operations, allowing for real-time monitoring of cash flows, investments and risk exposures. Regulatory compliance, particularly regarding key ratios, must be prioritised to avoid penalties and maintain operational integrity.
Strengthening governance within treasury functions by defining roles and accountability will support sound decision making. A robust maker-checker process is essential for ensuring transaction accuracy. Additionally, financial institutions should focus on enhancing stricter loan approvals, and improved loan recovery efforts to ensure adequate liquidity against future shocks.
In response to higher interest rates, achieving 鈥榠ntra-day control鈥� 鈥� real-time monitoring of liquidity positions 鈥� is vital. This enables quick adjustments to discrepancies. Financial institutions should leverage software solutions for comprehensive intra-day insights.
Lastly, restoring public confidence will require efforts from both regulators and banks to improve transparency and address governance issues, rebuilding trust in the financial system.
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Nurul Karim Patwery is head of treasury, IDLC Finance Plc.
