Liquidity Risk Management in Bank: A Conceptual Framework

Liquidity is a bank’s capacity to fund increase in assets and meet both expected and unexpected cash and collateral obligations at reasonable cost and without incurring unacceptable losses. In the context of banking, liquidity, or the ability to fund increases in assets and meet obligations as they come due, is critical to the ongoing viability of the banking institution. Since there is a close association between liquidity and solvency of banks, sound liquidity management reduces the probability of banks becoming insolvent, thus reducing the possibilities of bankruptcies and bank runs. Ultimately, prudent liquidity management as part of the overall risk management of the banking institutions ensures a healthy and stable banking sector. Effective liquidity risk management helps ensure a bank’s ability to meet its obligations as they fall due and reduces the probability of an adverse situation developing. This paper examines the sound practices for the liquidity risk management in banks. The paper goes along with the suggestions of the Basel Committee and Reserve Bank of India on management of liquidity risk. In this paper, we explain the meaning of liquidity, liquidity risk and liquidity management. It also discusses the process of building up of a liquidity risk management system.