ALM: Quantifying Liquidity Risk: Cost-to-Close Liquidity Gap Methodology
Asset Liability Management (ALM) includes effective Liquidity Management. One way of assessing a bank’s exposure to liquidity risk is to consider the gaps that exist between its assets and liabilities for pre-defined time buckets, and then calculate the cost that would be incurred to close out those gaps. The Cost-to-Close Liquidity Gap methodology is described in the post below.
Assets represent outflow of cash whereas liabilities represent an inflow of cash. When assets exceed liabilities there is a deficit of funds which could expose the financial institution to liquidity risk. In order for the bank to remain liquid the gap (i.e. net cash outflow) would need to be filled by funding from the market.
Let us take a simple example to illustrate this situation. Today, Alan deposits an amount of USD 300 with Bank Big for a period of 3 months. Bank Big then lends this USD 300 to Clint for 6 months. Let us assume that there are no further transactions undertaken. Bank Big’s liquidity gap report as of today will look as follows:
|Duration||Up to 3 months||3 – 6 months|
For the time bucket ‘Up to 3 months’ there is a negative liquidity gap, where liabilities exceed assets. This represents an excess of funds. Bank Big has a net cash inflow and therefore is not exposed to liquidity risk.
However in the next time bucket Bank Big has a positive liquidity gap. This indicates that Bank Big is exposed to liquidity risk as there is a deficiency of funds due to cash outflows exceeding cash inflows during this period. In order to compensate for this lack of liquidity the bank would need to fund the gap from the market either by decreasing its assets e.g. by selling off assets and/ or increasing its liabilities e.g. by borrowing from the market.
One measure of liquidity risk is the cost to close gap analysis. This analysis assumes that the positive gaps will be filled by borrowing from the market. The first step in this analysis is the definition of time buckets. Let us assume that the following time buckets have been defined:
- Up to 1 month (0.83 years)
- 1 month -3 months (0.25 years)
- 3 months – 6 months (0.50 years)
- 6 months – 9 months (0.75 years)
- 9 months -12 months (1 year)
- 1- 3 years (3 years)
- 3- 5 years (5 years)
The figures in brackets represent the upper bounds of the time intervals expressed in years. This figure will be used in the calculation of the cost to close measure as explained later.
After this all of the bank’s assets and liabilities will be grouped into these time buckets based on when the cash flow is expected to be received/ paid (i.e. its maturity or due date as opposed to its re-pricing date). This involves calculating each future cash flow/ installment going forward of each individual asset/ liability and then slotting each of these amounts into the relevant time buckets depending on when they are expected to be paid / received. The same process may also be applied to off-balance sheet items and non-funded exposures depending on the extent of the analysis being carried out.
Once each individual asset and liability future cash flow has been slotted into the appropriate bucket., the asset values for each bucket will be summed firstly across each asset category (e.g. advances) and secondly across the asset portfolio. In the same manner the liabilities values for each bucket will be summed firstly across each asset category (e.g. deposits) and secondly across the liability portfolio.
The difference between the total assets and liabilities for each time bucket will then be calculated. This difference represents the liquidity gap. A negative difference i.e. liabilities exceed assets indicates an excess of funds and could potentially be a source of interest rate risk to the bank as interest revenues (from investment of these excess funds) could be adversely affected by movements in the interest rates. A positive difference, i.e. assets exceed liabilities indicates deficient funds which is a source of liquidity risk for the bank as the bank has a net cash outflow for that time bucket.
We have presented a measure for assessing the liquidity risk that a bank is exposed to: the Cost-to-Close Liquidity Gap technique. In the following post we will present a simple example illustrating this methodology.