In order to understand the usefulness of VaR and other risk metrics for the setting of capital adequacy requirements it is useful to compare various measures used by financial institutions and legislative statutes of the Basel Frameworks. Traditional approaches to banking regulation emphasises the understanding that the existence of capital adequacy plays a central role in the long term financing and solvency positions of banks, especially in helping the banks to avoid bankruptcies and their negative externalities on the financial system (Dewaitpont and Tirole 1994) The notion of liquidity must be well defined ‘unfortunately the word, liquidity has so many facets that it is often counter-productive to use it without further and closer definition’ (Goodhart 2008). However; in the context of liquidity risk management, a bank’s liquidity can be defined as the ability to fund increases in assets and to finance obligations as they fall due. Therefore liquidity refers to the risk resulting (Nier 2005) from a financial institutions failure to pay its debts and obligations when due because of its inability to convert assets into cash readily. Moreover, liquidity risk also refers to the inability to procure sufficient funds due to high costs of liquidity transformation that may affect the financial institutions revenues and capital funding either now or in the future. The main objective of liquidity management is to ensure adequate liquidity in all circumstances so that banks have the ability to meet its cash flow obligations. Since maturity transformation of short-term deposits into long term loans is one of the banks fundamental roles banks are therefore inherently vulnerable to liquidity risk stemming from both an institutional-specific nature and a contagion effect which has the ability to cause a ‘ripple’ effect throughout global markets.
Several areas are of concern in the context of liquidity risk management, (Nier 2005) firstly data may be scarce and lacking in quality and historical data is not necessarily an accurate predictive agent; thus data may not be a reliable proxy for stress testing. Sound liquidity management for both short term and long run purposes is an integral component of a banks contingency funding plan that would aid banks in the event of a financial crisis. Fundamentally, liquidity risk measurement comprises four measurement systems (i) use of ratio analysis (Dowd 2002) where the applications of ratios are developed to measure various components of a bank’s balance sheet. Such ratios include the minimum liquid asset (MLA), the capital asset ratio (CAR) and the minimum cash balance (MCB). In addition a banks liquidity position needs to be monitored with the application of these ratios both on-balance-sheet and off-balance-sheet terms (ii) Cash flow measures; where a projection of cash flows based on both supply and demand for liquidity exists under normal market conditions. The recent global financial crisis has highlighted the importance of adequate liquidity of banks coupled with five key features relating to financial regulation and (Cross 2010) supervision; systematic risk, pro-cyclicality, regulatory arbitrage and transparency.
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