Liquidity Risk And Maturity Transformation In Banks Finance Essay

Liquidity Risk And Maturity Transformation In Banks Finance Essay

This research proposal will concentrate on one of the cardinal country of hazard in banking sector which is liquidness hazard. There are three definitions which are normally used for the liquidness. First one is the easiness that the fiscal instruments can be converted in to hard currency. Second is market construct of the liquidness is the ability to merchandise the assets or securities without losing its value. The last is the cautionary liquidness means the entire figure or entire measure of the liquid assets which are merchandising in the economic system. ( Adrian and Shin, 2008 ) . The intent of the literature reappraisal and thesis is tried to turn to the chief grounds of mismatching of assets and liabilities in Bankss.


Mismanagement of liquidness can take to bankruptcy. We can non distinguish liquidness and solvency in bank. Some clip the bank which is illiquid can be insolvent and on the other manus the bank which is insolvent can be illiquid. This is why the capital and liquidness adequateness public presentation is the major concern of the commercial bank. ( Good Hart, 2008 ) . Liquidity and solvency has the strong relationship. “ In Banking act of 1935 liquidness and solvency practically has become the synonymous footings ” . ( Walter A. Morton, 1939 ) . This is the fact that because of misdirection of the liquidness the fiscal market faced some singular events in 2007 and 2008. Burnermair presents his position about the crisis of 2007-08. “ Fiscal markets experienced extraordinary events in 2007 and 2008. The addition in delinquency rates of subprime mortgages, coupled with the mismatch in the adulthood constructions of off-balance-sheet conduits and structured investing vehicles ( SIVs ) , led to a sudden drying up of asset-backed commercial paper and the failure of several Bankss, including a authoritative bank tally in the United Kingdom. The eruptions in recognition and money markets finally led to a tally on one of the taking investing Bankss in the United States ” . ( Brunnermeier, 2008 ) . The liquidness cans effects in two ways or it has the two ways impact on the bank. One side is high liquidness ratio direct a positive signal to the depositors. This shows that the bank is liquid and it increase the assurance of the depositor and the lower degree of the liquidness means the bank is non in strong liquid place and will unable to pay its committedness. But if we see the other side high liquidness shows the inefficient usage of the resources. This shows bank will non efficient in investing activities and will lose the profitableness. ( Gunsel, 2010 ) .

This is really wide subject even the word liquidness has many definitions. As Good Hart says in one of his article “ Unfortunately the word ‘liquidity ‘ has so many aspects that it is frequently counter-productive to utilize it without farther and closer definition ” . ( Good Hart, 2008 ) .


The cardinal face or side of liquidness which we are traveling to cover in this research is the adulthood transmutation which means that the adulthood of assets and liabilities in balance sheet of bank. In normal pattern bank execute a valuable activity on either side of the balance sheet. On plus side they go for long term investings or do long term loan. They make loan for illiquid borrowers because they want flow of capital in economic system. On liabilities side they need liquidness on demand to depositors. There is mutual exclusiveness between these two activities. Demand for the liquidness can originate at inconvenient clip and can set the Bankss in problem. Other activities of the Bankss can be affected. This is why an ground forces of the regulators ever supervise the bank to protect them from their ain breakability. ( Douglas, 2001 ) .

Bank activities are link with all economic system and failure of one bank can make a multiplier consequence. One of the chief or most of import grounds for the crisis in fiscal sector is the failure of the bank because bank failure starts systemic hazard. ( Douglas W Diamond, 2005 ) . This is why the ordinance sing liquidness and capital demand has become excessively much of import.


There are three chief grounds for the ordinance of liquidness direction. Harmonizing to Adrian and Shin. “ First, pure market failures. There are no inducements for Bankss to keep equal sums of liquid assets because: ( 1 ) liquidness is dearly-won, particularly when competition drives the hunt for higher returns on equity ; ( 2 ) liquidness deficits are really low chance events ; ( 3 ) there is a perceptual experience that cardinal Bankss will step in and supply liquidness support if and when it is needed ( the moral jeopardy statement ) .Second, liquidness demands can be seen as a manner of sharing the cost of the “ public good ” of liquidness and fiscal stableness between the private and the public sectors. This would assist and extenuate moral jeopardy ; it would besides counterbalance for other inexplicit subsidies, such as sedimentation insurance, granted to the banking sector. Finally, stronger liquidness demands would cut down the strategic uncertainness impacting Bankss actions, since they would be able to defy larger dazes ” . ( Adrian and Shin, 2008 ) .

Basel commission is working since 1980 to take steps the issue of liquidness in bank. The concern of this commission is to make up one’s mind what should be the capital adequateness ratio. This average what should be the minimal degree of capital that fiscal establishments must hold to maintain. There should be the anterior criterion sing to adulthood transmutation. Harmonizing to author the criterion for the adulthood transmutation has non been maintained. The proportionate is traveling to be increased for funding long term assets with short term adoptions. In this facet what bank do “ they Conduits financing tranches of securitised mortgages on the footing of three month plus backed commercial paper ” . An illustration of this is Northern stone. The of import thing which come in our head who should be responsible to take in to consideration the issue of adulthood transmutation whether it should be cardinal bank or bank itself. For the instance of adulthood transmutation how long the bank will able to carry through its committednesss merely in instance the markets on which it relies all of a sudden dry up. . ( Good Hart, 2008 ) .


It has been seen since many old ages that adulthood mismatches in the balance sheet of the bank can take to liquidity crisis. It was one of the grounds of the East Asiatic crisis in 1998. ( Rajan and Bird, 2001 ) . This is one of the grounds that adulthood mismatch and the hazard associated in making this have got the considerable attending in markets. In bank its of import is cardinal because Bankss are in the concern of adulthood transmutation. They take assets and normally repaid on short notice and utilize these sedimentations to supply recognition installations to borrower for long period. In simple Bankss need liquidness to run into the depositor demand or with drawls, to settle whole sale committedness, to supply financess when borrowers draw on committed recognition installations. Under stress status adulthood transmutation is rather important. Because in crisis it is hard to raise liquidness from different beginnings. ( Financial supervising committee, 2005 ) . This average Bankss need to pull off the liquidness but from the above point of position Bankss can pull off liquidness to give short term loans because Bankss borrow for short term but this is non so easy.


Hendrik explained if the Bankss go for liquidness penchant they will give the short term loans but on the other manus borrowers demand long term loans because they want steady beginning of debt capital. ( Hendrik, 2006 ) . In the same paper Hendrik argued that “ Economic theory posits that fiscal establishments are exposed to a important involvement rate hazard which is mostly due to their battle in adulthood transmutation ” . Banks set loans on the footing of some criterions.

Borrowers with low recognition evaluations bank gives them short term loans and borrowers holding high recognition evaluation bank gives long term loan. ( Douglas, 1991 ) . So recognition evaluation of borrower is rather considered in adulthood transmutation.

Some clip attitude of the directors who are in determination devising is truly matter in adulthood transmutation. This phenomena sing hazard is explained by James. He said “ the thought of hazard is embedded, of class, the larger thought of the pick as affected by the expected return of an option. Virtually all the theories of the picks assume that determination shaper prefer larger expected returns to smaller one provided the other full factors constant ( hazard ) ” . ( Lindley, 1971 ) .

In general they besides assume that determination shaper prefer smaller hazard to larger one, provided other factors ( expected value ) are changeless. ( Arrow, 1965 ) . Thus the expected value is assumed to be positively associated, and hazard is assumed to be negatively associated with the attraction of an option. ” ( James, 1987 ) . So above statement shows director hazard pickings or hazard seeking attitude can consequence adulthood transmutation determination.

In normal pattern during adulthood transmutation Bankss prefer high involvement or high net income. They mismatch their liabilities and assets means borrow for short term and impart for long term. This pattern leads to liquidness hazard. This pattern of mismatching of assets and liabilities in balance sheets of Bankss is continued since many old ages and is the chief ground of the liquidness crisis. This mismatching of liabilities and assets has the important portion in East Asia crisis 1997-1998. Bank pays deficient attending to adulthood transmutation because they prefer high hazard and high return. This self involvement behavior leads to liquidness crisis. “ It is to reconfirm that liquidness crises can happen in the absence of bond out commissariats and can ensue merely from adulthood mismatches that themselves reflect the result of self-interested optimizing behavior by commercial Bankss ” . ( Rajan and Bird, 2001 ) . Bank capital construction besides influence on adulthood transmutation. Some bank have extra capital this mean their capital to plus ratio is good. So this thing besides affects the imparting behavior of the bank. By sing their capital construction they take the hazard and mismatch the adulthoods of assets and liabilities. ( Gambacorta and Mistrulli, 2003 ) .

From the above paragraph the different positions of the writers come in forepart sing grounds for the mismatching of the adulthoods. Following of import grounds have been indicated. Borrowers demand for the long term loan, recognition evaluation of the borrowers, hazard taking behavior, high profitableness and bank ‘s capital construction.


Most of investors prefer the loan holding short adulthood or footings. “ Now the commercial Bankss have created the off-balance sheet vehicle that converted or shorten the adulthoods of the long term merchandises. Investment Bankss now rely on nightlong repo markets to finance their balance sheet. So the inquiry is what these off- balance sheet vehicles are. Off balance sheet vehicles are the structured investing vehicle. This means invest in long term illiquid assets and publish short term adulthood paper in the signifier of plus backed commercial paper which have an mean adulthood of 90days and average term notes which holding the mean adulthood of one twelvemonth. Asset backed commercial paper was really popular in 2006. The off-balance sheet vehicles ‘ scheme of puting in long-run assets and borrowing utilizing short-run paper exposes them to funding liquidness hazard, since the commercial paper market might all of a sudden dry up. To guarantee support liquidness, the patronizing bank grants a recognition line, or a alleged liquidness backstop.3 Thus, the banking system still bears the liquidness hazard from the adulthood transformation-like in the traditional banking theoretical account of Bankss, in which commercial Bankss take on short-run sedimentations and put in long-run undertakings ” . ( Brunnermeier, 2008 ) . While transforming the adulthoods the Bankss or fiscal establishments has to see the concern of the investors. Investors are concerned with return which they can obtain on short notice. Because they are unsure about the demand of the financess. So the activities of the bank to supply the liquid investing chance. Banks do this through two channels. First bank sedimentations offer an option to obtain financess on short notice at lower chance cost as comparison to market. ( James, 1987 ) .


Above positions of the writer ‘s shows that how of import is the direction of liquidness in Bankss. No uncertainty it is of import in banking sector because of different grounds but this non means that other sectors non face liquidness hazard. All sectors combine to do economic system and failure of one sector will impact overall economic system of state. Holmstrom has explained in his article that direction of liquidness for both existent and fiscal sector is of import. If both sector will pull off their liquidness demand, will be better able to run their operations expeditiously and efficaciously without confronting liquidness deficits. ( Holmstrom, 2000 ) . Liquidity hazard direction is of import because liquidness deficit affect the whole system and consequence the overall economic system. ( Basel Committee on Banking Supervision, 2008 ) .


We have discussed the liquidness which means the easiness that the fiscal assets can be converted into hard currency. Liquidity is really of import and misdirection of the liquidness can take to bankruptcy. Banks can be insolvent because of the liquidness misdirection. This is the ground that capital adequateness ratio has the greater concern for the regulative organic structures. Basel commission is working since 1988 to get the better of the issue of capital adequateness. Because the stableness of the fiscal establishment is the concern of overall economic system. In Bankss how they transfer their adulthoods means assets and liabilities in balance sheet of Bankss so that to avoid liquidness hazard. Because the ground for the fiscal crisis in yesteryear this adulthood mismatching construction of the Bankss. They finance long term loans with short term adoptions and when the clip come to carry through their committednesss they are unable to bring forth liquidness. Why these establishments go for this mismatching construction because there are different grounds borrowers demand for the long term loan, recognition evaluation of the borrowers, hazard taking behavior, high profitableness and bank ‘s capital construction. So the fiscal establishments must hold the proper schemes sing liquidness.


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