central bank of nigeria bank of nigeria understanding monetary policy series no 34 c 2013 central...

CENTRAL BANK OF NIGERIA

UNDERSTANDING MONETARY POLICY SERIES

NO 34

c 2013 Central Bank of Nigeria

BANKING SYSTEM LIQUIDITY

Obiageri C. NdukweObiageri C. NdukweObiageri C. Ndukwe

10TH

ICYL DO EP PY AR RA TT ME EN NO TM

AnniversaryCommemorative

Edition

Central Bank of Nigeria33 Tafawa Balewa WayCentral Business DistrictsP.M.B. 0187Garki, AbujaPhone: +234(0)946236011Fax: +234(0)946236012Website: E-mail:

www.cbn.gov.ng [email protected]

ISBN: 978-978-52860-5-2

© Central Bank of Nigeria

iii

Central Bank of NigeriaUnderstanding Monetary PolicySeries 34, October 2013

EDITORIAL TEAM

EDITOR-IN-CHIEF

MANAGING EDITOR

EDITOR

ASSOCIATE EDITORS

Aims and Scope

Subscription and Copyright

Correspondence

Email:[email protected]

Moses K. Tule

Ademola Bamidele

Charles C. Ezema

Victor U. ObohDavid E. Omoregie

Umar B. Ndako Agwu S. Okoro

Adegoke I. Adeleke

Sunday Oladunni

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 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.

Enquiries concerning this publication should be forwarded to: Director, Monetary Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria,

Oluwafemi I. Ajayi

iv

Central Bank of Nigeria

Mandate

Vision

Mission Statement

Core Values

§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

“By 2015, be the model Central Bank delivering

Price and Financial System Stability and promoting

Sustainable Economic Development”

“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”

§Meritocracy

§Leadership

§Learning

§Customer-Focus

v

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

Central Bank of Nigeria

Mission

To Provide a Dynamic Evidence-based

Analytical Framework for the Formulation and

Implementation of Monetary Policy for

Optimal Economic Growth

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. TuleDirector, Monetary Policy DepartmentCentral Bank of Nigeria

FOREWORD

CONTENTS

vii

Section One:

Section Two: Conceptual Issues in Banking System Liquidity

Section Three: Sources of Banking System Liquidity

Section Four: Liquidity Risk

Section Five: Management of Banking System Liqudity in Nigeria

Introduction .. .. .. .. .. .. 1

2.1 Liquidity .. .. .. .. .. .. .. 32.2 Capital and Liquidity Nexus .. .. .. .. .. 42.3 Liquidity: Regulatory Requirement .. .. .. .. 4

.. .. .. 73.1 Asset Management .. .. .. .. .. .. 73.2 Liability Management .. .. .. .. .. .. 73.3 Funding Sources: Assets .. .. .. .. .. 7

3.3.1 Asset Sale .. .. .. .. .. .. 73.3.2 Asset Securitization .. .. .. .. .. 8 3.3.3 Loan Portfolio and Loan Commitments .. .. 83.3.4 Investment Portfolio .. .. .. .. .. 8

3.4 Funding Sources: Liabilities .. .. .. .. .. 83.4.1 Deposits .. .. .. .. .. .. 83.4.2 Wholesale and Market Based Funding .. .. 93.4.3 Public Funds .. .. .. .. .. .. 93.4.4 International Funding Sources .. .. .. .. 93.4.5 Central Bank Funds .. .. .. .. .. 93.4.6 Interbank Borrowings .. .. .. .. .. 93.4.7 Repurchase Agreements Transactions .. .. 10

.. .. .. .. .. .. 114.1 Red Flags to Declining Banking System Liquidity .. .. 11

4.1.1 High and Rising Interest Rates .. .. .. .. 124.1.2 Declining Deposit Money Banks' Closing Balances .. 124.1.3 Increased Demand for Secured Lending in the Interbank

Market .. .. .. .. .. .. .. 124.1.4 Increased Access to Central Bank Standing Lending

Facility .. .. .. .. .. .. .. 13

155.1 Monetary Policy Response to Deficit Banking System Liquidity

(The wake of the global financial crises 2008 - 2011) .. .. 155.2 Monetary Policy Response to Excess Liquidity in the Banking

System (2010 - 2014) .. .. .. .. .. .. 165.3 Policy Instruments Used by the Central Bank in Controlling Banking

System Liquidity .. .. .. .. .. .. 165.3.1 Cash Reserve Ratio .. .. .. .. .. 165.3.2 Liquidity Ratio .. .. .. .. .. .. 175.3.3 Loan to Deposit Ratio .. .. .. .. .. 175.3.4 Foreign Currency Trading Position .. .. .. 175.3.5 rDAS Introduction .. .. .. .. .. 18

Section Six: Conclusion

Glossary of Terms

Bibliography

5.3.6 Implementation of TSA .. .. .. .. 18

.. .. .. .. .. .. 19

.. .. .. .. .. .. .. 21

.. .. .. .. .. .. .. 23

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1

B A N K I N G S Y S T E M L I Q U I D I T Y 1

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

1This 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.

2Obiageri C. Ndukwe is an Economist in the Monetary Policy Department, Central Bank of

Nigeria.


2

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.


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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


4

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.


5

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

Banks

Balances held for external offices less

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


6

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.


7

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.


8

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.


9

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


10

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.


11

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.


12

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.


13

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.


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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.


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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


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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.


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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.


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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.


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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.


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