Analysis of Liquidity Risk and Profitability in Commercial Banking

This report delves into the critical aspects of bank liquidity risk within the context of commercial banking and finance. It begins by defining liquidity risk and exploring its various sources, including timing mismatches in cash flows, fluctuations in funding, and market behavior. The report then differentiates between asset and liability liquidity, highlighting their implications on a bank's balance sheet. Through the use of graphs, the report analyzes key financial ratios such as loan-to-deposit ratios, liquid asset to short-term funding ratios, and the Basel Liquidity Coverage Ratio for major Australian banks. Furthermore, it interprets liquidity risk, providing insights into the specific risk management practices of Bendigo and Adelaide Bank, National Australian Bank, and the Commonwealth Bank of Australia. Finally, the report examines the trade-off between liquidity and profitability, using data from the Commonwealth Bank of Australia to illustrate this complex relationship.

COMMERCIAL BANKING
AND FINANCE

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
QUESTION 1...................................................................................................................................1
a. Defining bank liquidity risk with its sources and examples....................................................1
b. Defining bank asset liquidity and liability liquidity along with different implication in their
balance sheets..............................................................................................................................2
QUESTION 2...................................................................................................................................3
a. Providing graphs ....................................................................................................................3
b. Interpreting liquidity risk........................................................................................................9
QUESTION 3.................................................................................................................................10
Explaining statement with data of a major Australian bank “There is a trade-off between
liquidity and profitability”........................................................................................................10
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Liquidity plays essential role in financial system's stability and its deficiency might create
default in fulfilling its particular financial obligations in normal situation. The present report is
giving brief discussion about bank liquidity risk with its sources. It had articulated liability and
asset liquidity with its implications in balance sheet. Further, it had stated graphs for loan to
deposit, liquid asset to short term funding and Basel liquidity coverage ratio. In the same series,
liquidity risk had been stated with appropriate evidence. Last but not least, there is explanation
about statement “There is a trade-off between profitability and liquidity” with proper support of
Commonwealth Bank of Australia's recent data.
QUESTION 1
a. Defining bank liquidity risk with its sources and examples
Liquidity is referred as capability of bank for meeting its obligations of cash and
collateral without sustaining losses which are unacceptable. The liquidity risk could be referred
as inability of bank for meeting its real or perceived obligations. The financial position or
existence has been threatened in this situation Geddes, Schmidt & Steffen, (2018). The capacity
of bank to fund had been represented for increment in its assets and to meet its due obligations
with absence of unacceptable losses. The fundamental objective pertaining to banks considers
transformation from liquid deposit liabilities to illiquid assets like loans which makes bank liable
for higher penalty to its liquidity risk.
There is brief classification of its sources of bank liquidity risk such as:
 The timing of cash out-flows and in-flows are improperly judged along with complacent
attitude of bank.
 Unexpected fluctuation in availability of funding and cost of capital.
 The aberrant behaviour of financial market in stress.
 Risk from secondary sources like: failure of business strategy and corporate governance,
policy of merger and acquisition and modelling assumptions.
 Different range of assumption applicable in forecasting cash flows.
 Imbalances related to macroeconomic
 Breakdown in settlement and payment system Mian & Santos, (2018).
The management of liquidity risk helps in ensuring ability of bank for performing its
fundamental functions. Some outflows are referred with certainty and risk had been arisen from
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requirement of meeting various cash flow obligations which are uncertain as they directly
depend on external events on nature of other agents. The mismatch of maturity is not only source
of liquidity risk. Its sources could be on asset side which highly depends on degree of inability
for bank to transform its assets into cash with absence of loss at required time. In the same series
on liabilities side it comes up from recall of unanticipated deposits Huang & Mazouz, (2018).
b. Defining bank asset liquidity and liability liquidity along with different implication in their
balance sheets
Asset Liquidity: Liquidity is referred as a measure of ease and capability where assets
are transformed in cash. Liquid assets of banks could be defined as quick conversion of cash due
to requirement of accomplishing financial obligations. Its examples could be central bank
reserves, government debt and cash. The scenario of liquidity must not focus on unexpected and
expected cash flow but also on asset liquidity as various institutions highly rely for generating
liquidity from position of security. It must consider:
 Requirement of funding for short term perspective due to temporary disruption with
context of liquidity.
 The distressed environment for longer term with interbank difficulties, tightening of
credit lines and distress in particular currencies.
 Change in deposit consumption with its increment of withdrawals and selling of asset
is impossible in specific duration.
 In nutshell its sources are investments, loans, borrowing lines and brokered deposits.
Liability Liquidity: In this category, usually funds are borrowed by bank to meet its
obligations. It is very mandatory to meet requirements of liquidity. The composition of liability
especially demand level such as current and saving bank accounts in context of term liabilities
like fixed deposit Kariv, Kotowski & Leister, (2018). Generally, its applications consider
unfunded loan commitment, maturity of deposits or borrowed fund with various level of
uninsured deposit along with growth initiatives. The requirement letter of Federal Reserve is to
identify cash amount and due from balances of bank account as it should be properly maintained
on basis of present level of bank deposits.
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QUESTION 2
a. Providing graphs
Customer Loan
/ Customer
deposit
2013 2014 2015 2016 2017
National
Australian bank 104.19 101.67 107.92 108.23 106.97
CBA 107.06 107.47 103.66 107.67 107
ANZ 98.95 96.6 91.02 95.15 93.93
Westpac Bank 118.83 112.41 120.8 121.32 120.53
Customer loan / Customer deposit
It is referred to as loan to deposit ratio which is applicable for assessing liquidity of bank
by providing comparison of same duration. Generally, it is expressed in percentage format.
Loans are made by bank to its borrowing customers and simultaneously it generates both liability
and credit for borrowers along with bank as well. It is considered as very important ratio; high
ratio signifies more of deposits issued through bank with context of interest bearing loans. In
simple words it could be stated that more income would be generated. The main issue is that
bank loans are not always repaid easily (Annual Financial Report of Westpac banking
corporation, 2017).
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Liquid Assets / Deposit and short term funding
2013 2014 2015 2016 2017
National
Australian bank 24.07 25.34 34.1 34.23 34.5
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CBA 9.38 10.16 11.7 10.89 13.08
ANZ 25.47 26.2 26.92 27.46 26.84
Westpac Bank 16.59 16.28 10.4 8.8 9.09
This ratio specifies value of assets which are easily converted in cash to its total deposits
and short term funding. Liquid assets consists of trading securities, cash and various dues via
banks, cash collaterals and reverse repos. Short term funding consists of customer deposits such
as term, savings and current and borrowings of short term like money market instruments, CDs
and various other deposits Alper & et. al., (2018).
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Basel Liquidity coverage ratio for the four major Australian banks from 2013 to 2017
Banks 2013 2014 2015 2016 2017
Bendigo and Adelaide Bank
Limited 0 0 122.20% 0 122.20%
National Australia Bank
Limited 0 0 0 0 123.00%
CBA 0 0 120.00% 120.00% 128.60%
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The above graph is of liquidity coverage ratio as per Basel of Commonwealth Bank of
Australia, Bendigo and Adelaide and national Australia Bank.
b. Interpreting liquidity risk
Bendigo and Adelaide Bank: In every operation of banking because of mismatch of
timing among cash outflow and inflow. In this it is stated as Group's risk with inability to meet
its obligation of payment because of dues, consists of maturing wholesale debt and repaying its
depositors and lack of capacity of fund to raise its assets Bai, Krishnamurthy & Weymuller,
(2018). The main objective is to provide surety about commitments of cash flow which are not
accomplished in an appropriate manner. There is presence of ineffective business plans, adverse
business decisions and fails for responding towards alterations in operating environment which
causes capability for delivering objectives and strategies of business. In the same series, there are
specific range of laws, standards, regulations, industry codes and policy. The alterations in
regulations and law, policies or code might affect banks in various unpredictable aspects such as
increase in investments, procedure and staff to comply along with particular regulatory
requirements (Annual Financial Report of Bendigo and Adelaide bank, 2017).
This specific group has set indicators as early warning for supporting process of liquidity
risk management with context to risk increment and vulnerability in position of liquidity.
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