Setting limits for liquidity risk
In general liquidity limits have to be assessed for ‘normal’ business operation conditions as well as for stressed scenarios to ensure that there is sufficient liquidity at all times. The following should be considered when determining liquidity risk limits:
1. The company’s risk appetite
2. The level of the company’s capital
3. The level of the company’s earnings
4. The perceived likelihood of an unusual funding need
5. The level of confidence in measures of current and projected liquidity
6. The company’s level of immediately available liquidity
7. The ability to quickly and reliably convert standby liquidity sources into cash
8. The relationship between the potential risk and the potential reward
9. The other risk exposures to which the bank is currently exposed
10. The time periods, scenarios and stress levels that the limits will be calculated for
The following limits may be determined.
Cash flow mismatch or gap limits
Limits on discrete (or individual) and cumulative cash flow mismatches or gaps over specified short- and long- term horizons under both expected and adverse business conditions need to be set. These could be in the form of cash flow or liquidity coverage ratios or specified aggregate amounts based on historical averages or desired targets.
Maturity limits are useful for liquidity risk control. These limits control exposure by controlling the volume or amount of securities that mature in a given time period. By staggering the maturities of the securities, the company can reduce the volatility as well as control the liquidity position of the company at any given time period.
Target Liquid Reserves
Set targets for unpledged liquid asset reserves. These are usually expressed as aggregate amounts or as ratios.
a. Asset concentration limits need to be set in particular with respect to more complex exposures that are illiquid or more difficult to value.
b. Funding concentration limits that address diversification issues relating to the nature of the deposits or the sources of borrowed funds
Concentration limits have to be assessed in terms of the maturity patterns/ nature of liabilities.
Contingent liability limit
These limits are set so that the amounts of unfunded loan commitments and lines of credit remain reasonable relative to available funding.
Limits should be reviewed at least annually to account for changes in
- the size and composition of the company’s balance sheet and off-balance sheet positions,
- market conditions and
- regulatory guidance
Limits will usually be set at two levels, a few ‘hard’ limits as approved by the Board set for cumulative buckets and at higher levels and many guidance or threshold limits set for individual buckets and secondary or sub levels.
Violation of hard limits will lead to immediate corrective actions to improve the liquidity and interest rate positions or will require board approval if the situation is to be treated as an exception. Violations to guidance or threshold levels would lead to closer monitoring, more frequent reporting and/ or additional analysis.