- Funding Liquidity Risk: Inability to raise funds when needed.
- Market Liquidity Risk: Inability to sell assets quickly at fair value.
Understanding liquidity risk is essential for CAIIB candidates because many exam questions focus on liquidity ratios, contingency funding, maturity mismatch, ALM, and governance frameworks.
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Board of Directors’ Role in Liquidity Risk Governance
- Setting the bank’s overall liquidity risk appetite.
- Approving policies, processes, and risk limits.
- Receiving regular liquidity and stress test reports.
- Ensuring senior management and committees implement effective frameworks.
ALM Support Group Role & Structural vs Flow Approach
ALM Support Group Role
- Monitoring maturity mismatches between assets and liabilities.
- Assessing currency mismatches, especially in overseas operations.
- Preparing structural liquidity and flow-based statements.
- Supporting the Contingency Funding Plan (CFP).
Structural Liquidity (Stock) vs Flow Approach
| Approach | Focus | Key Output |
|---|---|---|
| Stock | Balance sheet structure and core funding | Liquidity gap, core deposit ratio |
| Flow | Projected inflows/outflows over time buckets | Cash flow projection, stress scenario |
Liquidity Ratios & Core Deposit Ratio
- Core Deposit Ratio: Core deposits ÷ total deposits — higher ratio indicates funding stability.
- Volatile Liability Ratio: Volatile liabilities ÷ total liabilities — lower ratio means lesser risk.
- Liquidity Coverage Ratio (LCR): HQLA ÷ 30-day net outflows ≥ 100%.
- Net Stable Funding Ratio (NSFR): Stable funding ÷ required funding ≥ 100%.
Contingency Funding Plan (CFP): Elements & Correct Factors
The CFP is a pre-approved plan to deal with funding stress situations. Key elements include:
- Trigger indicators and early warning signals.
- Identified emergency funding sources.
- Clear escalation and approval matrix.
- Defined governance and communication plan.
- Regular review and testing process.
Market Liquidity Risk & Overseas Operations / Currency Mismatch
Market liquidity risk arises when assets cannot be converted to cash quickly without loss.
In overseas operations, liquidity risk can arise due to currency mismatches between assets and liabilities.
- Currency mismatch occurs when assets and liabilities are in different currencies.
- Differences in funding availability across countries amplify this risk.
Flow vs Stock Approach & Maturity Mismatch Limits
- Flow Approach: Focus on short-term liquidity position.
- Stock Approach: Focus on long-term funding structure.
- Maturity Mismatch Limits: Banks define allowable gaps between maturing assets and liabilities.
Risk Management Committee (RMC) & ALM Committee Roles
Risk Management Committee (RMC)
- Oversees identification and monitoring of liquidity risk.
- Reviews stress test and limit breaches.
- Recommends policies to the board.
ALM Committee
- Sets liquidity and funding strategy.
- Monitors daily liquidity gaps.
- Implements contingency funding actions.
Statement of Structural Liquidity & Internal Audit Evaluation
- Statement of Structural Liquidity shows maturity profile and core funding ratio.
- Internal audit ensures policy compliance, data integrity, and model validation.
BCBS Principle 6 – Monitoring & Control
Principle 6 focuses on monitoring and controlling liquidity risk through defined metrics, reporting, and independent review.
Banks must ensure that their framework includes stress testing, reporting, and internal audit review mechanisms.
Important Questions for CAIIB – Liquidity Risk Management
- Differentiate between funding liquidity risk and market liquidity risk.
- Explain the significance of the Core Deposit Ratio.
- What is the difference between Flow and Stock approach?
- List the elements of a Contingency Funding Plan (CFP).
- What is the role of the Board of Directors in liquidity management?
- Explain the ALM Support Group’s role in liquidity monitoring.
- Define Maturity Mismatch Limits and their purpose.
- Differentiate the roles of RMC and ALM Committees.
- What is a Statement of Structural Liquidity?
- Explain the concept of Volatile Liability Ratio.
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Summary & Final Words
- Liquidity Risk Management is crucial for every bank and examiner’s favorite topic.
- Understand governance roles, key ratios, CFP, and maturity mismatches.
- Master both Flow Approach and Stock Approach.
- Revise all important ratios like Core Deposit, Volatile Liability, LCR, and NSFR.
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