The Seesaw of Liquidity and Exposure
Liquidity and exposure are two important concepts in the banking industry that relate to a bank's financial stability and risk management.
Liquidity refers to a bank's ability to meet its short-term obligations, such as customer withdrawals and payment obligations, without incurring significant losses or disruptions to its operations. Maintaining adequate liquidity is crucial for the smooth functioning of a bank and to instill confidence in depositors and creditors.
Banks typically hold liquid assets, such as cash, government securities, and highly marketable and easily convertible financial instruments, to ensure they have sufficient funds to meet their obligations. Regulatory bodies often set liquidity requirements, such as CRR and SLR in maintaining a certain level of liquid assets relative to a bank's liabilities, to safeguard against liquidity crises.
A lack of liquidity can lead to a bank's inability to fulfill its obligations, resulting in financial distress or even failure as in the case of SVB. Banks manage liquidity risk by closely monitoring their cash flows, maintaining diversified funding sources, and implementing liquidity risk management strategies. Currently, the Indian Banking system sits on an estimated 2 trillion liquidity surplus.
Exposure refers to the potential risk or vulnerability a bank faces due to its various assets, liabilities, and off-balance-sheet activities. It includes both credit exposure and market exposure. High exposure to the banking system threatens to create liquidity issues or credit crunch in the event of an economic slowdown.
Credit Exposure represents the risk of losses arising from borrowers failing to fulfill their obligations. Managing credit exposure involves evaluating the creditworthiness of borrowers, diversifying loan portfolios, setting appropriate credit limits, and implementing risk mitigation techniques like collateral requirements and credit risk transfer instruments. Each bank has its own exposure limit for an organization and an overall group exposure that it can take.
The Reserve Bank of India allows for no more than 25% of a bank's available eligible capital base to be exposed to any one group of connected companies. Public sector banks in India have in the past been hit by massive corporate defaults.
If a bank has a large amount of credit exposure, it can impact its liquidity position. If borrowers default on their loans or fail to make payments, the bank may face a liquidity squeeze as it struggles to generate sufficient funds to meet its own obligations.
For example, if a bank has a significant portion of its loan portfolio concentrated in a particular industry or geographic region, and that industry or region experiences financial distress, the bank's credit exposure increases, and there is a higher likelihood of loan defaults. This can potentially drain the bank's liquidity reserves as it tries to cover the losses.
Banks proactively manage liquidity risk to ensure they can withstand unforeseen events or financial stress. This involves assessing their overall exposure to credit and market risks and maintaining sufficient liquid assets to meet obligations even under adverse conditions.
By diversifying their loan portfolios, implementing risk management frameworks, setting appropriate credit limits, and employing hedging strategies, banks can reduce their exposure to potential losses and mitigate liquidity risks. Adequate liquidity buffers also provide a cushion to absorb unexpected credit or market-related shocks.
Effective risk management practices, diversification, and liquidity planning are essential to maintain a healthy balance between exposure and liquidity, ensuring a bank's stability and ability to meet its obligations.
Kautilya, IBS Mumbai.