How Banks Manage Liquidity Risk

How Banks Manage Liquidity Risk

Posted by on Jun 28, 2021

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Similar to investors and small businesses, banks also take on liquidity risk. Banks' management of liquidity risk isn’t much different from how investors and businesses manage liquidity risk. They all must ensure that cash flow (i.e., income) arrives before bills come due. 

With banks being heavily regulated, there’s more of a spotlight on their liquidity management. In this article, we’ll go into the details of how banks manage liquidity risk and what impact that may have on real estate investors.


What Is Bank Liquidity?

Liquidity means that a bank is able to meet its obligations. In other words, if a bank can pay its obligations, it is liquid. As a result, the bank doesn't need to be flush with cash. Instead, it may draw on credit lines to pay its obligations. It might also borrow from another bank or entity. Whatever the source, if the bank is liquid, it has access to liquidity at will.


What Is Liquidity Management?

Banks must constantly calculate their liquidity. Knowing where liquidity stands on a daily basis demonstrates if the bank can meet its cash flow and collateral needs without negatively impacting daily operations or its overall financial position (i.e., as perceived by other entities). All of this falls under liquidity management.

While liquidity management is important to banks, it also has far-reaching consequences. For example, should a bank become insolvent or even rumors of its insolvency spread, a run on the bank may occur, potentially further deteriorating its situation. 

Ultimately, this may affect creditors, who could also fail. A localized crisis can quickly spread into a systemic crisis, as was the case in the Great Financial Crisis of 2008-2009.

For those reasons, banks are heavily regulated entities. One of those regulations is called Basal IV, which is part of an international banking standard known as the Basel Accords. 

It requires that banks project (through regulatory calculations) their liquidity situation into the future and determine if they are able to meet liquidity requirements. Banks should know their liquidity situation at any given time and be able to produce it upon request. Accurate liquidity calculations require good data and record keeping.

Banks maintain their liquidity profile through a reserve of liquid assets, which include government bonds and management of liabilities. A component of liability management is the maturity ladder or profile. This means liabilities are due further out than the income arriving from a bank’s loan portfolio, a scenario also known as the liquidity gap.

A maturity profile categorizes liabilities into different categories based on the date that the liability comes due or matures. Some examples are listed below:

  • 1-3 months
  • 90-120 days
  • 3-12 months
  • 1+ years

If income were to arrive later than the due date for liabilities, the bank would experience a cash flow crunch. Cash on hand would not be able to pay for bills coming due. A cash flow crunch can start a cycle where a bank cannot get ahead of its liabilities and ultimately becomes insolvent.

Proper liquidity management can help banks minimize the impact of market shocks. It also allows the bank to perform liquidity projections and stress tests.


What Is Bank Liquidity Risk?

Banks can experience liquidity risk from unexpected deposit withdrawals, credit disbursements, and a dependence on market assets that suffer a loss of liquidity. One of the main sources of liquidity, in this case, might be other banks, which may be unlikely to lend to the bank given its liquidity risk to them.

If outflows continue and the bank is unable to cover them, it may have to start selling illiquid assets. Because of the nature of illiquid assets, the bank will be limited in its ability to liquidate those assets. The end result of the liquidations will likely be a large loss of assets.


Impact on Real Estate

The source of funding for many real estate deals is bank loans. Banks maintain a portfolio of real estate property loans and monitor the performance of those properties. If properties begin experiencing cash flow issues, as was the case during the pandemic with tenants not being able to pay rent, some properties may begin experiencing a liquidity crisis. This, of course, creates liquidity risk for banks. In some cases, not only does the property experience a loss of cash flow, but it may also experience a decrease in value.

For property owners or operators, a strong rapport with their lender is critical. It can mean the difference between a successful negotiation on loan terms vs. automatic triggers on loan covenants due to lack of compliance.

Bank liquidity risk may seem unrelated to real estate investing. However, the strength of a sponsor’s or investor’s portfolio becomes more important when the economy starts turning down or certain sectors begin experiencing a decline. This is when banks may begin calling in loans or issuing restrictions to borrowers. Investors can also monitor this risk by staying on top of their properties’ cash flows and tenants’ credit risk.


This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

 


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