Liquidity risk is the inability of a bank to meet its financial obligations. This happens when the bank is holding onto a hard asset, or a security, which it cannot convert to cash without suffering unwanted losses. Liquidity risks can be attributed to unexpected withdrawals of large amounts of investment accounts. Adequate liquidity is when a bank is able to meet expected and unexpected cash flows and collateral needs. Liquidity risk management is the efforts made to shelter these financial institutions from liquidity risk exposure.
In a study of relation between profitability and liquidity, Eljelly (2004) found that a major negative relations between the firms profitability and its liquidity level when measured by current ratio. Firms with higher current ratios and longer cash conversion cycles showed more negative relations between liquidity and its profitability. Cash gap is of more significance as a measure of liquidity than current ratio that affects profitability.
In times of financial crisis, banks that rely more on core deposits and equity capital financing lend to other banks. Banks that held onto illiquid assets on their balance sheets by contrast increase asset liquidity and minimize loaning money out.
The guiding principles of liquidity risk management are to promote development of practical and transparent financial service industry by introducing new and adopting existing standards and rules. The second principle is to provide guidance on effective monitoring and regulation of financial institutions and developing a criterion for identifying, measuring, managing and divulging risks.
Banks in Saudi Arabia incorporated liquid risk management systems that enable them to cope with liquidity risks.The banks are monitored by Saudi Arabian Monetary Authority (SAMA) to ensure the appropriateness of their liquidity risk management. The financial institutions recognize the risks associated with intra group funding. The banks have also strengthened their resilience in stress phase. Lastly, the institutions have put a plan in place in case of liquidity emergency.
In order for liquidity risk management guidelines to work effectively, there has to be in place adequate laws, including on securities, capital market, contract, bankruptcy and asset recovery laws. There should be surveillance on the financial institutions to monitor the impact of potential shocks on financial soundness. A secure and efficient payment and clearing system should be put in place. A regulation for timely and relevant information dissemination to stakeholders is enacted. Also a designed mechanism to provide appropriate level of systematic protection is put in place. Lastly, a framework for dealing with insolvency, and associated rules, rights and obligations for recovery of financing and that third parties to the transaction including financiers, investors, depositors and other stakeholders.
There are a couple of factors which affect the liquidity risk management practices in Saudi Arabian banks. One of the factors is when these financial institutions fail to take into account the basic principles of liquidity risk managements. Banks expose themselves to liquidity risks when they implement inadequate framework to cater for liquidity risks posed by individuals products and business line, hence incentives are misaligned with the overall risk of tolerance of bank. Malfunctioning policies, management oversight and risk monitoring strategies implemented are inadequate.
Failure to properly implement liquidity risk management strategies could lead to banks becoming insolvent. A bank is said to be insolvent when its assets value cannot cover the cost of its obligations. This means that for a bank to be cushioned from the risks of liquidity risks, they have to fully implement liquidity risk management regulations that are usually in the directives from Saudi Arabian Monetary Authority (SAMA). The banks have to adopt a different policy on what they base their operations on, that is, put more emphasis on core deposits, rather than assets in their balance sheets.
Eljelly A, 2004, Liquidity- profitability tradeoff: an empirical investigation in emerging markets. International Journal of Commerce and Management Vol. 14 Issue 2 pg. 46-61 doi: 10.1016/105691080000179
Santomero A, 1997, Commercial bank risk management: an analysis of the process. Journal of Financial Services ResearchVol. 12 Issue 2, pg. 83-115 doi: 10.1023/A.100791801810
Cornett M, Manutt J, Tehranian H, 2011, Liquidity risk management and credit supply in the financial crisis. Journal of Financial EconomicsVol. 101 Issue 2 pg. 297-312 doe: 10.1016/j.jfineco.2011.03.001
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