A. Measuring and managing net funding requirements

The analysis of net funding requirements involves the construction of a maturity ladder and the calculation of a cumulative net excess or deficit of funds at selected maturity dates. A bank's net funding requirements are determined by analysing its future cash flows based on assumptions of the future behaviour of assets, liabilities and off-balance-sheet items, and then calculating the cumulative net excess over the time frame for the liquidity assessment.

(i) The maturity ladder

In constructing the maturity ladder, a bank has to allocate each cash inflow or outflow to a given calendar date from a starting point, usually the next day. (A bank must be clear about the clearing and settlement conventions it is using to determine its initial point.) As a preliminary step to constructing the maturity ladder, cash inflows can be ranked by the date on which assets mature or a conservative estimate of when credit lines can be drawn down. Similarly, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option, or the earliest date contingencies can be called. Significant interest and other cash flows should also be included. The difference between cash inflows and cash outflows in each period, the excess or deficit of funds, becomes a starting-point for a measure of a bank's future liquidity excess or shortfall at a series of points in time.

It is this net funding requirement that requires management. Typically, a bank may find substantial funding gaps in distant periods and will endeavour to fill these gaps by influencing the maturity of transactions so as to offset the gap. For example, if there is a significant funding requirement 30 days hence, a bank may choose to acquire an asset maturing on that day, or seek to renew or roll over a liability. The closer a large gap gets, the more difficult it is to offset. Thus, banks will typically collect data on relatively distant periods so as to maximise the opportunities to close the gap before it gets too close. Most banks would regard it as important that any remaining borrowing requirement should be limited to an amount which experience suggests is comfortably within the bank's capacity to fund in the market.

(ii) Alternative scenarios

1. The going-concern scenario establishes a benchmark for the "normal" behaviour of balance sheet-related cash flows in the ordinary course of business at a bank. This scenario is useful in managing a bank's use of deposit and other debt markets. By establishing such a benchmark, a bank can manage its net funding requirements so that it is not faced with very large needs on any given day, so avoiding the impact of temporary constraints on its ability to roll over liabilities because of market disruptions or concerns about its condition.
2. Assessing liquidity under the second scenario, a liquidity crisis at an individual bank that remains confined to that bank, provides one type of "worst-case" benchmark. The key underlying assumption in this scenario is that many of the bank's liabilities could not be rolled over or replaced and would have to be repaid at maturity so that the bank would have to wind down its books to some degree. This is the scenario implicit in many existing bank supervisory liquidity measures. While a severe liquidity crisis at an individual bank usually stems from a fundamental, bank-specific problem not related to its liquidity, a bank's ability to honour its deposit maturities under such conditions can provide the time that the bank would need to address the underlying problem. If a bank can weather such a "worst-case" scenario, it can almost certainly survive less drastic firm-specific problems.
3. The last scenario is some form of general market crisis where liquidity is affected at all banks in one or more markets. The key underlying assumption that banks need to make in this scenario is that severe tiering by perceived credit quality would occur, so that differences in funding access among banks or among classes of financial institutions would widen, benefiting some and harming others. Although some banks may believe that central banks would ensure that key markets would continue to function in some form, severe market disruption would not necessarily be prevented. For bank management, this represents a second type of "worst-case" scenario that a bank would wish to weather. A supervisor or central bank may find this scenario to be of particular interest when surveying the liquidity profile of the entire banking sector. The collective results would suggest the size of the total liquidity buffer in the banking system and the likely distribution of liquidity problems among large institutions if the banking system as a whole experiences a shortage of liquidity.

Hence, the timing of cash inflows and outflows on the maturity ladder can differ between the going-concern approach and the two crisis scenarios, as shown in Table 2. In constructing the going-concern maturity ladder, conservative assumptions need to be made about the behaviour of cash flows that can replace the contractual cash flows. For example, many maturing loans would be rolled over in the normal course of business and some proportion of transactions and savings deposits would also be rolled over or could be easily replaced.

In a bank-specific crisis scenario it is assumed that a bank will be unable to roll over or replace many or most of its liabilities, and that it may have to wind down its books to some degree. The assumptions under the third scenario, a general market crisis, may differ quite sharply from the assumptions made for a bank-specific crisis. For example, a bank may believe, based upon its historical experience, that its ability to control the level and timing of future cash flows from a stock of saleable assets in a bank-specific funding crisis would deteriorate little from normal conditions. However, in a general market crisis, this capacity may fall off sharply if few institutions are willing or able to make cash purchases of less liquid assets. On the other hand, a bank that has a high reputation in the market may actually benefit from a flight to quality as potential depositors seek out the safest home for their funds. Banks may also anticipate that central banks would ensure that key markets continue to function but not necessarily without significant disruption.

(iii) Measuring liquidity over the chosen time-frame

It is important to note that the relevant time-frame for active liquidity management is short, generally extending out no more than a few weeks. While most banks would not actively manage their net funding requirements over a period much longer than four or five weeks, managements may consider information on requirements beyond that time frame to be useful. Clearly, banks active in markets for longer-term assets and liabilities will need to use a longer time-frame than banks which are active in short-term money markets and which are in a better position to fill funding gaps at short notice. However, even this latter category of banks may find it worthwhile to tailor the maturity of new transactions to offset gaps some time off.

A longer time horizon may also generate useful information on which to base more strategic decisions on the extent to which a bank may rely on particular markets.

(iv) Assumptions used in determining cash flows

(a) Assets

Determining the level of a bank's potential assets involves answering three questions:

• what proportion of maturing assets will a bank be able and willing to roll over or renew?
• what is the expected level of new loan requests that will be accepted?
• what is the expected level of draw-downs of commitments to lend that a bank will need to fund? These commitments may take the form of committed commercial lines without material adverse change (MAC) clauses, which a bank may not be legally able to turn away even if the borrower's financial condition has deteriorated; committed commercial lines with MAC clauses which some customers could draw down in crisis scenarios; and other commercial and consumer credit lines.

Roll-overs, draw-downs and new loan requests all represent potential cash drains for a bank. Nevertheless, a bank has some leeway to control many of these items depending on the assumed scenario. In a crisis situation, for example, a bank might decide to risk damaging some business relationships by refusing to roll over loans that it would make under normal conditions, or it might refuse to honour lending commitments that are not binding.

In determining the marketability of assets, the approach segregates the assets into three categories by their degree of relative liquidity:

• the most liquid category includes components such as cash, securities, and interbank loans. Some of these assets may be immediately convertible into cash at prevailing market values under almost any scenario (either by outright sale, or for sale and repurchase, or as collateral for secured financing), while others, such as interbank loans or some securities, may lose liquidity in a general crisis;
• a less liquid category comprises a bank's saleable loan portfolio. The task here is to develop assumptions about a reasonable schedule for the disposal of a bank's assets. Some assets, while marketable, may be viewed as unsaleable within the time frame of the liquidity analysis;
• the least liquid category includes essentially unmarketable assets such as loans not capable of being readily sold, bank premises and investments in subsidiaries, as well as, possibly, severely troubled credits;
• assets pledged to third parties are deducted from each category.

In categorising assets, a bank would also have to decide how an asset's liquidity would be affected under different scenarios. Some assets that may be very liquid during times of normal business conditions may be less so during a time of crisis. Consequently, a bank may place an asset in different categories depending on the type of scenario it is forecasting.

(b) Liabilities

To evaluate the cash flows arising from a bank's liabilities, a bank would first examine the behaviour of its liabilities under normal business conditions. This would include establishing:

• the normal level of roll-overs of deposits and other liabilities;
• the effective maturity of deposits with non-contractual maturities, such as demand deposits and many types of savings accounts;
• the normal growth in new deposit accounts.

In examining the cash flows arising from a bank's liabilities in the two crisis scenarios, a bank would examine four basic questions:

• which sources of funding are likely to stay with a bank under any circumstance, and can these be increased?
• which sources of funding can be expected to run off gradually if problems arise, and at what rate? Is deposit pricing a means of controlling the rate of runoff?
• which maturing liabilities or liabilities with non-contractual maturities can be expected to run off immediately at the first sign of trouble? Are there liabilities with early withdrawal options that are likely to be exercised?
• does the bank have back-up facilities that it can draw down?

The liabilities that make up the first category may be thought to stay with a bank, even under a "worst-case" projection. Some core deposits generally stay with a bank because retail and small business depositors may rely on the public-sector safety net to shield them from loss, or because the cost of switching banks, especially for some business services such as transactions accounts, is prohibitive in the very short run.

The second category, liabilities that are likely to stay with a bank during periods of mild difficulties and to run off relatively slowly in a crisis, includes core deposits that are not already included in the first category. In addition to core deposits, in some countries, some level of particular types of interbank and government funding may remain with a bank during such periods, although interbank and government deposits are often viewed as volatile. A bank's own liability roll-over experience as well as the experiences of other troubled institutions should help in developing a timetable for these cash flows.

The third category comprises the remainder of the maturing liabilities, including some without contractual maturities, such as wholesale deposits. Under each scenario, this approach adopts a conservative stance and assumes that these remaining liabilities are repaid at the earliest possible maturity, especially in crisis scenarios, because such money may flow to government securities and other safe havens. Factors such as diversification and relationship building are seen as especially important in evaluating the extent of liability run-off and a bank's capacity to replace funds. Nevertheless, in a general market crisis, some high-quality institutions may find that they receive larger-than-usual wholesale deposit inflows, even as funding inflows dry up for other market participants.

Some banks, for example, smaller banks in regional markets, may also have credit lines that they can draw down to offset cash outflows. While these sorts of facility are somewhat rare among larger banks, the possible use of such lines could be addressed with a bank's liability assumptions. Where such facilities are subject to material adverse change clauses, of course they may be of limited value, especially in a bank specific crisis.

(c) Off-balance-sheet activities

A bank should also examine the potential for substantial cash flows from its off-balance-sheet activities (other than the loan commitments already considered), even if such cash flows are not always a part of banks' current liquidity analysis.

Contingent liabilities, such as letters of credit and financial guarantees, represent potentially significant cash drains for a bank, but are usually not dependent on a bank's condition. A bank may be able to ascertain a "normal" level of cash outflows on an ongoing concern basis, and then estimate the scope for an increase in these flows during periods of stress. However, a general market crisis may trigger a substantial increase in the amount of draw-downs of letters of credit because of an increase in defaults and bankruptcies in the market.

Other potential sources of cash outflows include swaps, written over-the-counter (OTC) options, and other interest rate and forward foreign exchange rate contracts. If a bank has a large swap book, for example, then it would want to consider the circumstances under which the bank could become a net payer, and whether or not the potential net payout is significant. For example, if a bank is a swap market-maker, the possibility exists that in a bank-specific or general market crisis, customers with in-the-money swaps (or a net in-the-money swap position) would seek to reduce their credit exposure to the bank by asking the bank to buy back swaps. Similarly, a bank would need to review its written OTC options book and any outstanding warrants, together with any hedges against these positions, since certain types of crises may stimulate an increase in early exercises (for American-style options) or requests that the bank repurchase options. These exercises and repurchase requests could result in an unforeseen cash drain, if hedges either cannot be quickly liquidated to generate cash or provide insufficient cash.

(d) Other assumptions

The discussion has centred so far on assumptions concerning the behaviour of specific instruments under various scenarios. Looking solely at instruments, however, may ignore some factors that may significantly impact a bank's cash flows.

Besides the liquidity needs arising from business activities, banks also require excess funds to support other operations. For example, many large banks provide clearing services to correspondent banks and financial institutions that generate significant and not always easily predictable cash inflows and outflows, the amounts of which depend on the clearing volumes of the correspondent banks. Unforeseen fluctuations in these volumes can deplete a bank of needed funds.

Net overhead expenses, such as rent and salary, although generally not significant enough to be considered in banks' liquidity analyses, can in some cases also be sources of cash outflows.

B. Managing market access

Some liquidity management techniques are viewed as important not only for their influence on the assumptions used in constructing the maturity ladders, but also for their direct contribution to enhancing a bank's liquidity. Thus, it is important for a bank to review periodically its efforts to maintain the diversification of liabilities, to establish relationships with liability-holders and to develop asset-sales markets.

As a check for adequate diversification of liabilities, a bank needs to examine the level of reliance on individual funding sources, by instrument type, nature of the provider of funds, and geographic market. In addition, a bank should strive to understand and evaluate the use of intercompany financing for its individual business offices.

Building strong relationships with some providers of funding can provide a line of defence in a liquidity problem and form an integral part of a bank's liquidity management. The frequency of contact and the frequency of use of a funding source are two possible indicators of the strength of a funding relationship.

Developing markets for asset sales or exploring arrangements under which a bank can borrow against assets is the third element of managing market access. The inclusion of loan-sale clauses in loan documentation and the frequency of use of some asset-sales markets are two possible indicators of a bank's ability to execute asset sales under adverse scenarios.

C. Contingency planning

A bank's ability to withstand a net funding requirement in a bank specific or general market liquidity crisis can also depend on the calibre of its formal contingency plans. Effective contingency plans should address two major questions:

• does management have a strategy for handling a crisis?
• does management have procedures in place for accessing cash in emergency?
• The degree to which a bank has addressed these questions realistically, provides management with additional insight as to how a bank may fare in a crisis.

(i) Strategy

A game plan for dealing with a crisis should consist of several components. Most important are those that involve managerial coordination. A contingency plan needs to spell out procedures to ensure that information flows remain timely and uninterrupted, and that the information flows provide senior management with the precise information it needs in order to make quick decisions. A clear division of responsibility must be set out so that all personnel understand what is expected of them during a crisis. Confusion in this area can waste resources on certain issues and omit coverage on others.

Another major element in the plan should be a strategy for taking certain actions to alter asset and liability behaviours. While assumptions can be made as to how an asset or liability will behave under certain conditions (as discussed above), a bank may have the ability to change these characteristics. For example, a bank may conclude that it will suffer a liquidity deficit in a crisis based on its assumptions regarding the amount of future cash inflows from saleable assets and outflows from deposit run-offs. During such a crisis, however, a bank may be able to market assets more aggressively, or sell assets that it would not have sold under normal conditions and thus augment its cash inflows from asset sales. Alternatively, it may try to reduce cash outflows by raising its deposit rates to retain deposits that might otherwise have moved elsewhere.

Other components of the game plan involve maintaining customer relationships with borrowers, trading and off-balance-sheet counterparties, and liability-holders. As the intensity of a crisis increases, banks must often trade off relationships with some customers for liquidity in order to survive. By classifying borrowers and trading customers according to their importance to the bank, a bank can determine which relationships it may need to forgo at different points in a crisis. At the same time, relationships with lenders become more important in a crisis. If a bank's strategy requires liability managers to maintain strong ongoing links with lenders and large liability-holders during periods of relative calm, the bank will be better positioned to secure sources of funds during emergencies.

An additional, pragmatic element that may be important is how a bank deals with the press and broadcast media. Astute public relations management can help a bank avoid the spread of public rumours that can result in significant run-offs by retail depositors and institutional investors.

(ii) Back-up liquidity

Contingency plans should also include procedures for making up cash flow shortfalls in emergency situations. Banks have available to them several sources of such funds, including previously unused credit facilities and the domestic central bank. Depending on the severity of a crisis, a bank may choose - or be forced - to use one or more of these sources. The plan should spell out as clearly as possible the amount of funds a bank has available from these sources, and under what scenarios a bank could use them.

Table 1
The maturity ladder based on contractual maturities

Table 2
Day 1 of the maturity ladder under alternative scenarios