Banks Liquidity Risk Management 1 Essay Example

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Banks Liquidity Risk Management

City and State Where Institution is Located

Table of Contents

Liquidity risk management in banks: A comparison between National Australian Bank and Adelaide & Bendigo Bank

Introduction

Companies rely on funds in running their operations with a considerable portion of the funds being taken from debts. The major concern for creditors is the ability of companies to meet their obligation to pay both interest as well as the principal. Thus, this results in liquidity concerns and thus liquidity risk for the company as failure to meet the above obligations on time would threaten its operations. Duttweiler (2009) states that companies ought to maintain high liquidity levels so that they can have enough assets convertible to cash in a timely manner to meet their obligations on time. This is because low liquidity levels will imply less cash convertible assets and hence will be unable to meet their obligations on time. This would increase liquidity risk that would threaten their operations while on the other hand, lenders prefer lending to companies with low liquidity risk and hence a bank with a low liquidity risk will have more sources of funds. Banks also called upon to regulate their liquidity risk so that they can ensure safety of depositors’ funds while enhancing their reputation. In Australia, the Australian Prudential Regulatory Authority (APRA) has been given the responsibility of regulating the way banks operate so that they can properly manage their liquidity thus protecting the welfare of their various stakeholders (Tarantino, 2011). APRA therefore requires banks to adhere to its liquidity management policies. This paper compares the liquidity management practices undertaken by NAB and Bendigo & Adelaide bank in their attempt to comply with APRA’s requirements. In this regard, the two banks’ diversification of funding, maturity mismatch levels among other measures will be examined.

Liquidity Risk Management Practices

The various stakeholders for banks are concerned of the bank’s ability to give them a return on their investment while remaining in operation by ensuing it meets its financial obligations on time. This is the essence of APRA’s policies on liquidity. The paper thus conducts a liquidity risk management analysis of the above banks which is aimed at revealing the bank that is better placed to meet its financial obligations (Ruozi and Ferrari, 2013).

The liquidity management practices adopted by the two banks are in line with BASEL III and APRA’s liquidity risk management recommendations. NAB observes the following principles in managing its liquidity risks;

1. Monitoring the bank’s liquidity position on a daily basis, using a combination of contractual and behavioral modelling of balance sheet and cash flow information.

2. Maintaining a high quality of liquid asset portfolio that supports intra-day operations and can be sold in time of market stress (NAB, 2016)

3. The bank operates a prudent funding strategy that ensures appropriate diversification and limits maturity concentrations.

4. The bank maintains a contingent funding plan that is designed to respond to the event of an accelerated outflow of funds

5. The principle requires the bank to have the ability to meet a range of survival horizon scenarios

These principles are also applied by Adelaide & Bendigo bank and are in line with the revised APRA prudential standards aps 210 that includes the use of the scenario based liquidity coverage ratio (LCR) and maintaining a ratio of high quality assets (HQLA) to cover defined projected cash outflows over a 30 day period, use of other liquid assets and having a diversified sources of funding. Thus, it can be concluded that the two banks’ are in line with APRA’s requirements although differences may exist as to the level of liquidity risk management (BEN, 2016). The various liquidity risk management measures utilized by the banks are compared below.

Comparison of maturity mismatch

Maturity mismatch occurs when the bank mismatches its balance sheet by having more short-term liabilities compared to its short term assets including possessing more assets than liabilities for medium and long-term obligations (Wu, 2011). Changes in the bank’s maturity profile is therefore an indication of the bank’s ability to borrow since the bank’s propensity to pay its current obligations depends on its balance sheet showing current liabilities and assets that are relatively equal.

Figure 1: Comparison of maturity mismatch

Percentage	Bendigo and Adelaide bank	Percentage	National Australian Bank
	53,098.9			Short Term Assets
	60,593.9			Short term Liabilities
	113,692.8

The appendix below provides the maturity ladder analysis for the two banks for the year 2016. However, it should be noted that BEN does not provide information on its assets and hence in this regard, I consider NAB to have provided more information and hence its exposed to less liquidity risk.

From the table above, it is clear that the short term assets for both BEN and NAB banks are far less than current liabilities which is an indication of a mismatch in both the banks’ balance sheets. However, NAB has a greater mismatch than BEN meaning that BEN has a greater propensity to pay its financial obligations to creditors by utilizing its current assets when compared to NAB. Thus, BEN can be said to have more liquidity than NAB in this respect.

Loans to deposit ratio

The ratio also gives an indication of maturity mismatch and hence liquidity risk as it indicates whether loans as a component of total assets is able to meet the bank’s total deposits which are part of the bank’s current liabilities (Deloitte.com, 2017).

Figure 2. Loans-to-Deposit (LTD) Ratio

From the above table, NAB has slightly greater amount of loans in comparison to deposits while BEN has slightly less loans compared to deposits. This means that NAB has a greater ability to meet its obligations to depositors using the loan assets when compared to BEN. This means that BEN has a greater likelihood of defaulting in its obligations to depositors when compared to NAB and thus in this regard, NAB can be regarded as more liquid.

The liquidity Coverage Ratio (LCR)

LCR as provided by Basel III requirements aims at promoting the short-term resilience of the liquidity risk profile of banks through ensuring banks have an adequate stock of unencumbered high quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet the banks’ liquidity needs for a 30 calendar day liquidity stress scenario (IMF, 2017).

Figure 2. Liquidity Coverage Ratio (LCR)

The above table shows that both companies had an LCR greater than 100 which is the APRA requirement. As such, both company are considered liquid as far as LCR is considered although NAB is considered more stable since it has a greater LCR.

Comparison of the banks’ diversification of Liabilities

APRA recommendations are that banks use various types of financing in funding its capital requirements for them to be able to minimize their liquidity risks. Thus, APRA dissuades banks from relying on only one source of finance in funding their capital requirements as this would expose them to being severely affected if an unfavorable event that impacts their sources of funds occur. On the other hand, banks are likely to face less risk if they will spread their liabilities in different capital sources as they attempt to diversify risk and thus effectively manage the liquidity risk. The table below shows how NAB and BEN have diversified their liquidity risk

Figure 4. Allocation of Fund Sources ($ million)

Percentage		Percentage
	57,054.7			Deposits
				Debt from other institutions
				Subordinated debts
				Convertible preference shares
				Loan capital
	58,729.9

The table above gives an indication that majority of capital in both banks is funded through deposits. The subordinated debts in NAB account for 20.26% compared to BEN’s 0.99%. Debts from other institutions form 6.95% in NAB compared to just 0.46% in BEN. On the other hand, NAB has no convertible preference shares while BEN did not have loan capital. Though it is clear that both banks have diversified funding sources, NAB has less liquidity risk in this respect since its capital is not almost entirely funded through deposits at 70% unlike NAB whose deposits constitutes more than 97%.

Intra Group Liquidity

BEN had liquid asset portfolio amounting to $m7, 542.2 in 2016 which is a slight decline from the 2015 level of $m7, 620.6 (Bendigoadelaide.com.au, 2017). On the other hand, NAB’s liquid asset portfolio in 2016 was $m118, 268 which was a decline from the 2015 level of $m123, 603. This therefore shows that NAB has more liquid assets in comparison to BEN and hence it can be considered more liquid than BEN. This means that BEN may be exposed to more intragroup liquidity risk than NAB.

Comparison of the two banks access to wholesale markets

Management of liquidity risk could also be enhanced by use of wholesale funds from other stable institutions as well as from the government. The benefits accruing from the bank accessing wholesale funds include lowered interest rates that are charged on the borrowed capital and the long duration required for the funds repayment. These funds are also easily accessible to the bank.

Figure 6. Wholesale Funds: 2016

BEN (Million)	NAB (Million)
$4,441.7

From the above figure, NAB has far higher amount of wholesale funding in comparison to BEN. The wholesale funding was however sourced from diversified sources including from the government, domestic and foreign sources. However, given the scope of operations, NAB may have greater sources of wholesale funding due to its scope of operations (nab.com.au, 2017). Thus, NAB could be considered more liquid that BEN in this case due to its ability to access more wholesale funding.

Comparison of foreign currency and other markets

Banks are also exposed to liquidity risk owing to the dynamic nature of the exchange rates in the various markets they operate. In this regard, the two banks have put up measures for dealing with foreign exchange rate risks such as investing in various forms of derivatives so as to hedge against exposure to interest rate risks through its nature of operations in diverse markets. This way, the banks protect themselves against foreign exchange risks when they borrow capital from foreign institutions and when customers conduct transactions in foreign markets. However, it is worth noting that NAB is relatively exposed to more risk in comparison to BEN owing to the scope of its operations (Bendigoadelaide.com.au, 2016). However, the resultant risk for both banks is greatly minimized as a result of the measures that the banks have put in place.

Industry Liquidity Support Arrangements

Owing to the nature of their operations, banks face huge liquidity problems that are likely to have negative impact on their liquidity. Thus, the reserve bank of Australia (RBA) and the Association of Prudential Authority (APRA) play a major role in providing of liquidity support to the banks which are likely to experience major liquidity risks. NAB & BEN are allowed to borrow from the reserve bank when they experience liquidity risk that may not be resolved despite their applying the various liquidity risk management measures. It should however be noted that RBA acts as the lender of the last resort for the banks and thus lends only when the banks liquidity problems are likely to affect the interests of many of its stakeholders as well as that of other financial institutions adversely.

Thus, before NAB and BEN are hit by worst liquidity problems, they could apply to be supported by APRA through its liquidity management policies aimed at enhancing their liquidity. These would include advice on internal liquidity policies and controls that allow liquidity improvement. On the other hand, RBA would provide the banks with monetary liquidity support.

Comparison of types of HQLAs

The diversity of a company’s HQLA is also an important liquidity risk management strategy for banks since these are the assets that banks would easily covert into cash in a bid to meet their obligations and hence the amount of HQLA a bank holds is an indication of its level of liquidity risk.

During the 3^rd quarter of 2016, NAB had HQLA comprising $91 billion which mainly consisted of level 1 assets including cash, deposits with common wealth government securities and securities issued by foreign investors. On the other hand, BEN had HQLA amounting to $4 billion which comprised of deposits with the reserve bank of Australia, Australia semi-government and commonwealth government securities and other securities eligible for repo with the RBA. Thus, it can be argued that there is no major difference between how the two banks HQLAs are diversified and thus their liquidity risk is assumed to be similar.

Conclusion

Resulting from the above analysis, both the banks have largely complied with APRA’s policy guidelines on liquidity and have also put in place various measures to enhance their liquidity. These include setting limits on maturity mismatch, maintenance of liquid asset portfolio and diversifying liabilities among other measures. However, the analysis does establish some differences in liquidity risk management for the two banks. For instance, NAB has more liabilities on its balance sheet when compared to BEN as well as Assets although NAB has a bigger maturity mismatch than BEN. Both banks have however taken measures to minimize liquidity risk that would arise from changes in exchange rates in various markets where they operate. In addition, NAB has more liquid assets when compared to BEN while its liabilities are more diversified. As such, this paper concludes that NAB has less liquidity risk when compared to BEN despite the various liquidity risk management measures being similar. This means that various stakeholders are more likely to be comfortable in investing in NAB as opposed to BEN if the two banks liquidity risk management is compared.

References

Bendigo and Adelaide Bank annual report 2016

National Australian Bank annual report 2016

West Sussex,Managing liquidity in banks: A top-down approach. Duttweiler, R. (2009).

U.K.: John Wiley & Sons.

Liquidity risk management in banks: Economic andRuozi, R., & Ferrari, P. (2013).

U.S.A.: Springer. Regulatory issues.

Hoboken, NJ: JohnEssentials of risk management in Finance.Tarantino, A. (2011).

Wiley & Sons.

Heidelberg, Germany:Quantitative financial risk management.Wu, D. D. (2011).

Springer-Verlag.

. Retrieved May 27, 2017, from;Risk and regulatory review: It’s timeDeloitte.com. (2017).

https://www2.deloitte.com/content/dam/Deloitte/au/Documents/financial- services/deloitte-au-fs-risk-regulatory-review-1014.pdf

. Retrieved May 27, 2017, from;Australia: Basel core principles for effective banking supervisionIMF. (2017).

https://books.google.co.ke/books?id=C_Q4m95FKOcC&pg=PT109&lpg=PT109&dq=A PRA+liquidity+risk+management+policies&source=bl&ots=tcgqLbYyv8&sig=YtBfP48 406gfJsVS6eaRbZZ8Ay0&hl=en&sa=X&redir_esc=y#v=onepage&q=APRA%20liquidit y%20risk%20management%20policies&f=false

. Retrieved May, 27, 2017, from;2016 Pillar 3 report: Incorporating the requirements of APS 330nab.com.au. (2017).

https://www.nab.com.au/content/dam/nabrwd/About- Us/shareholder%20centre/documents/2016-full-year-pillar-3-report.pdf

Bendigoadelaide.com.au. (2016). Base III pillar 3 disclosures: Prudential Standard APS 330. Retrieved May 27, 2017, from;

https://www.bendigoadelaide.com.au/public/shareholders/pdf/aps_330/2015-12-31- APS330.pdf

Bendigoadelaide.com.au. (2017). Base III pillar 3 disclosures: Prudential Standard APS 330. Retrieved May 27 2017, from;

http://www.bendigoadelaide.com.au/public/shareholders/pdf/aps_330/2016-12-31- APS33.pdf

Appendices

Appendix 1: NAB Maturity ladder analysis

Appendix 2: BEN Maturity ladder