liquidity risk management and basel 3 framework

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Money demand

The demand for money arises from two important functions of money; medium of exchange and the

store of value. The study of the demand for money is not restricted to the money market, but also involvesother market such as the commodity, capital and foreign exchange market

The purpose of the theory of demand for money is to look at the variables that motivate people to holdpart of there wealth in money as opposed to other assets. According to Jhingan (2004), there are threeapproaches to the demand for money:(1) The classical approach; (a) the equation of exchange; b) the cash balance (Cambridge) approach(2) The Keynesian approach(3) The post Keynesian approach

Classical approach said that money acts as the medium of exchange and facilitates the exchange ofgoods and services. There views were expressed in the fishers equation of exchange;MV = PQwhere, M = the quantity of money; V = its velocity of circulation; P = price level and Q = total outputHere, MV = Money supply, while PQ represents the demand for money. At equilibrium, money demand

(PQ) equals money supply (MV). The underlying assumption in the equation of exchange is that people

hold money to buy goods and does not explain fully why people hold money.

Keynes published The General theory of employment, interest and money in 1936.Keynes (1936) introduced three reasons or motives for holding money; the transactionary, precautionary

and the speculative or portfolio motive. Each of these motives is associated with one component of the

demand for money examined by Keynes.

Transactionary demand for moneyThis arises from the need to hold cash for current personal and business expenditure. There is hardly anyeconomic unit whose cash receipt perfectly matches its cash payments at all times. Monthly salaryearners receive their remuneration on monthly basis, some weekly and some on bi-monthly basis but notall foodstuffs could be bought and stored up till the next salary period. Even if this possible, otherexpenses like transport to work and newspaper will have to be on daily basis or at shorter intervals thanreceipt or income.The situation appears similar for must business goods may have to be sold on credit or on monthlybillings but daily expenses have to be made. Even for government, most company profit tax and tradingsurplus of government owned corporations accrue mostly at year ends but again daily expenses will haveto be met. The diversity in the timing of inflow and outflow of funds create the need to hold some cash tomeet daily expenses till the next cash inflow period.Therefore, the higher the level of income of an economic unit, the higher will be the transactions demand

for money and vice versa, hence M t = F(Y) where F > 0. The important thing to note here is that whileKeynes explicitly recognize that the transactions demand for money (Mt) depends on interest rate, he

argued that the influence of interest rate was minor compared to that of income

Precautionary demand for moneyThe precautionary demand, according to Keynes arises from the need to provide for unforeseen eventrequiring sudden expenditures. Unforeseen events as ill health, accidents and robbery/theft happen sosudden hence the need to hold cash to meet such unexpected cash needs. The higher the level ofincome of an economic unit, the higher will be the precautionary demand for money by the individual or


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the higher will be the money needed to meet unexpected expenditures and vice versa. Hence Mp =F(Y),F > 0. While Keynes explicitly recognized that precautionary money demand depends on interest rate, heargues that the influence of interest rate was minor compared with that of real income.

The speculative demand for moneyThe speculative demand according to Keynes arises from uncertainty about future interest rate. Keynes

emphasized risk and the uncertainty of expectations as the reasons behind the negative relationshipbetween the interest rate and the speculative demand for money. For example, in general theory, he

wrote that uncertainty as to the future course of the rate of interest is the sole intelligible explanation of

this relation. Through speculative demand for money, Keynes extended another function of money, that

is, store of value. In this function, there are two component parts; the transaction demand which is a

positive function of income while the demand for securities (bonds) are negatively related to interest rate.

The determinant of the demand for bonds is the price of bond and the interest on bonds. The higher the

level of interest rate, the lower is the speculative demand for money and vice versa

Liquidity risk management and Basel 3 framework

Liquidity is the capacity of a bank capacity to meet the funding of increase in the assets and be in

a position to handle both expected as well as unexpected cash and other collateral obligations in a

sufficient manner and at a reasonable cost. Liquidity risk is the banks inability to meet such

obligations as and when they become due.Effective liquidity risk management make it possible for

a bank to ensure meeting its obligations and reduces the probability of an uncalled adverse

situation or crisis . This is significanct because of the fact that the occurrence of liquidity crisis,

even at a single institution , economy or organization can have systemic implications on the whole

system on a global basis.The liquidity risk for a bank can be a funding liquidity risk or a market

liquidity risk.

The costsof banking crises are extremely high but, unfortunately, the frequency has been aswell. Since 1985, there have been over 30 banking crises in Basel Committee-membercountries. Roughly, this corresponds to a 5% probability of a Basel Committee member countryfacing a crisis in any given year a one in 20 chance, which is unacceptably high. [See Table 2]

Many countries may not have been the cause of the current crisis, but they have been affectedby the global fall out. Moreover, history has shown that banking crises have occurred in allregions of the world, affecting all major business lines and asset classes. Moreover, there tendto be a common set of features that seem to repeat themselves in various combinations frombanking crisis to banking crisis. These include:

Excess liquidity chasing yields

Too much credit and weak underwriting standards

Underpricing of risk, and

Excess leverage

In the current crisis, these recurring trends were magnified by:


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Weak bank governance practices, including in the area of compensation

Poor transparency of the risks at financial institutions and in complex products

Risk management and supervision focused on individual institutions instead of also at the

system level

Procyclicality of financial markets propagated through a variety of channels, and

Moral hazard from too-big-too-fail, interconnected financial institutions.

C. Benefits of tighter regulation through Basel III exceed the costs

The objective of the Basel III reforms is to reduce the probability and severity of future crises.This will involve some costs arising from stronger regulatory capital and liquidity requirementsand more intense and intrusive supervision. But our analysis and that of many others has foundthe benefits to society well exceed the costs to individual institutions. The Committees long -term economic impact analysis found that capital and liquidity requirements could be increased

well above current minimum levels while still achieving positive net economic benefits. [seeTable 3]

These findings are not surprising. It is widely accepted that prudent fiscal and monetary policies

are the cornerstones of financial stability and sustainable economic growth. Indeed, maintaining

conservative fiscal and inflation policies involve a cost they result in potentially lower short-

term economic growth, which is offset by more sustainable long-term growth. Increasing stability

of the banking and financial system involves a similar trade-off, where the costs are more than

offset by the long-term gain. In particular, it is difficult to imagine a country that can maintain

sustainable growth on the foundation of a weak banking system

After the financial crisis 4 years back , BCBS(Basel Committee on Banking Supervision) recognized

need to improve the liquidity risk management of the banking structure , and published Principles

for Sound Liquidity Risk Management and Supervision in Sep 2008. And provided this framework

under Basel 3 norms which had 17 principles and had a guided structure from measuring the

liquidity situation to the monitoring and anticipation as well. It also provided the limits for the inter-

bank transfer as well as liquidity coverage risk as well as level 2 assets on the basis of liquidity .For

measuring the net funding requirements, there are two approaches being allowed and followed :

the stock approach and the flow approach.

In a high growth economy like India, there was a a huge asset liability mismanagement in stock

approach , so RBI has implemented the flow approach for measuring cash flow and short term and

long term mismatches at different time horizons. The cash flows are required to be placed on the

basis of the residual maturity of cash flows as well as the projected future cash flow behaviour of

assets, liabilities andmost importantly off-balance sheet items. The difference between cash


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inflows and outflows in each time period thus becomes a starting point for the measure of a banks

future liquidity surplus or deficit, at a series of points of time.


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The above table shows the benchmarks under the stock approach .This is just a miniscule of the

plethora of the benchmarks laid out in Basel 3 . But it suffered from drawbacks of being operated inan isolation as a sole measure. In a high growth economy like India, there was a a huge asset

liability mismanagement in stock approach , so RBI has implemented the flow approach for

measuring cash flow and short term and long term mismatches at different time horizons. The cash

flows are required to be placed on the basis of the residual maturity of cash flows as well as the

projected future cash flow behaviour of assets, liabilities andmost importantly off-balance sheet

items. The difference between cash inflows and outflows in each time period thus becomes a

starting point for the measure of a banks future liquidity surplus or deficit, at a series of points of

time.


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The first step is to have an effective liquidity risk management policy for liquidity management

which inter alia, should be a comprehensive under all conditions to spell out the liquidity risk

management and tolerance, various funding strategies, terms and limits of prudential limits,

system in place for the measurement , assessment and report /reviews of liquidity. It should also

encompass the framework for various stress tests, alternative scenarios liquidity plans and a formal

funding plan for contingency .Last, but not least , it should also cover a periodical review of

assumptions underlying in projection of liquidity . The Policy should also be in a position to address

liquidity individually for the individual currencies, various legal entities, and multidimensional

business lines when appropriate. Finally , it should allow legal, regulatory, as well as the

operational limits for the liquidity transfers.


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liquidity risk management and basel 3 framework

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