Causes of recent liquidity crisis of banking sector

Liquidity refers to the supply of the means of payments of an

economy. In Bangladesh, the totality of liquidity is indicated by what is

called 'broad money' or M2. A shortage of money restricts demand by making

it more difficult to engage in transactions. Investment is particularly

susceptible to liquidity. Now the main causes of liquidity crisis of

banking sector are given below:

In the recent year, our country has experienced a decline in the value

of Tk against US currency which has created has huge liquidity crisis in

the banking sector. For this reason our country has failed to collect

maximum amount of US dollar required to open letter of credit (LC) for

local businessmen to import essential commodities for the country. As

a result the importer is facing a severe crisis in their business.

The banks need to reserve huge amount of money with the

Bangladesh Bank as it is mandatory for them to maintain the CRR and

SLR. BB has recently increased the rate of CRR and SLR as a result the

problem of liquidity crisis has been aggravated recently. The central

bank during last December raised the cash reserve requirement (CRR)

by six percent for commercial bank.

As the increased percentage of CRR and SLR the commercial

bank is facing liquidity problem and for this reason to get rid of

the problem this banks are concentrated to generate more

deposits. To generate more deposits they have to increase the

deposit rate which has a adverse effect in the society.

 

Government credit from banking sector that would create extra burden

to the country’s banking sector and it creates more liquidity crisis in

that sector. the government has already borrowed Tk 110 billion from

the country’s banking sector to met the existing budget deficit during

last 10 months (July 2010 to April 2011), while last year it repaid Tk

87.92 billion loans. In the recent future the commercial banks will be

unable to provide loan to the private sector.

If the bankers do not abide by the norms of the central bank and lend out money un judiciously, there arises the problem with liquidity.

  The abnormal long-term finance and unsatisfactory recovery position

of short-, medium- and long-term loans will adversely affect the

liquidity situation.

The liquidity crisis of the banking sector has been accelerated by the

increased amount of inflation; thus increasing the price of overall

commodities for the general people. To keep peace with this

inflationary effect, the people withdraw their savings from the banks

and use this fund for their transactionary expenditure. As a result the

bank faces liquidity crisis.

The reason of liquidity crisis, if any persisting in the financial sector

may be the non-recovery of loans. The overall percentage of recovery

of loan is very alarming. By now the state-owned banks have taken

many steps to recover their old loans but could not show any

improvement. The state-owned public limited companies should give

due consideration to waiver of interest. But the businessmen or traders

who failed to repay loans due to various reasons cannot afford to bear

the burden of huge interest and suit costs.

 

In yearly period, the commercial banks perform activities

of investment banks, and for investment banks to also perform

activities of commercial banks (i.e. to borrow short and to lend long).

As a result there is a combination problem of liquidity risk and credit

risk and the problem becomes more uncontrollable and severe.

Overexposure in deposit-lending ratio, credit to deposit ratio (CDR) is

causing the liquidity crisis of the private commercial banks (PCBs).

Besides to make windfall profit and engaged in unhealthy competition

amongst the banks leading the banking into a deep crisis. Although the

Bangladesh Bank (BB) has set June 30 as deadline for bringing down to

CDR to a rational level, still many of the private banks are lagging

behind to maintain it, according to a BB official.

Relationship of liquidity with the reserve and call money rate: Excess

reserve with Bangladesh Bank has been decreased by BDT70 billion in

first six months, indicating an active money market.

The excess reserve is hard cash deposited by banks in addition to cash

reserve requirements, and it lies idle with the central bank and bears

no return. Repo and reverse repo rate were both raised by 50 basis

points to 6% and 4% respectively, causing liquidity to drop. Now we

will see the graphical presentation of the relationship of the excess

reserve and the liquidity of the banks.

Call money rate rose to double digit in December 2010 (Figure 2)

mainly due to increased demand for fresh funds in the inter-bank

money market. The demand for fresh funds was slightly higher on the

day following the increment of cash reserve requirement (CRR) by the

central bank to curb inflationary pressure on the economy. Under the

new rules, the commercial banks will have to maintain a CRR of 6.00%

instead of the previous 5.5% with the central bank from their total

demand and time liabilities on a bi-weekly basis.

The proposed budget created a liquidity crisis in the banking sector

due to its over-reliance on domestic borrowing for implementing the

annual development program. If the government borrows hugely for

implementing the ADP, the industrial sector will not get enough loans

from the banking system, which will ultimately lead to a higher bank

interest rate. In the budget for the next fiscal year, the government

proposed bank borrowing of Tk 18,957 crore for meeting the deficit

and spending in different sectors. Raising the tax at source to 1.5

percent from 0.40 percent will hamper the country's exports.

How banks manage liquidity risk

Liquidity risk management is a crucial area of risk control that is not covered

by the original Basel II accord. Liquidity Risk is the risk of not being able to

meet obligations when they come due because it cannot:

Liquidate assets or obtain adequate funding , this is called "funding liquidity

risk". Easily unwind or offset specific exposures without significantly lowering

market prices because of inadequate market depth or market disruptions,

which is called "market liquidity risk".

The dual definition of the liquidity risk helps in understanding the nature of

the risks; while funding liquidity risk focuses on company specific funding

problems, market liquidity risk describes general market liquidity disruptions.

The core of the liquidity risk strategy of a commercial bank must include

following main components;

Regular monitoring of net funding position and net funding gap of the

bank;

The Treasury monitors all maturing cash flows, replenishes existing funds as

they mature, monitors expected withdrawals from retail current and savings

accounts and makes additional borrowings and regularly issues new debt.

Diversification of funding sources;

The bank should posses well diversified funding sources including customer

current accounts credit balances, savings and retail deposits and inter-bank

deposits.

Broad portfolio of highly liquid assets;

The bank has to maintain a broad portfolio of highly liquid or marketable

assets that can be easily used to obtain cash. These assets can provide

liquidity through repurchase agreements or through sale.

Matching long term funding (over 12 months).

Fixed rate funding over 12 months and/or interest swaps (converting fixed

rate liabilities over 12 months in floating rate liabilities).

Set up quantitative limits and the limit structure.

Set up clear crisis organization structure and escalation procedure.

Tested and up-to-date contingency funding plans;

The contingency plans should address temporary and long-term liquidity

disruptions caused by a crisis. These plans ensure that all roles and

responsibilities are clearly defined.