7.3. Liquidity Risk

Effective from Nov 23 2011 - Nov 22 2011
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Liquidity risk is the risk of potential loss to a bank due to either its inability to meet its obligations in a timely manner or its inability to fund increases in assets /conduct a transaction at the prevailing market prices. The liquidity risk may arise from various sources including the significant mismatches in maturity structure of assets and liabilities, changes in interest rates which may encourage depositors to withdraw their deposits to seek better returns elsewhere, downgrading of credit rating and adverse market reputation which may pose challenges in accessing fresh liquidity, etc. Furthermore, derivatives and other off-balance sheet exposures may also become a source of liquidity risk and, therefore, banks should take into account the impact of off-balance sheet items and commitments in undertaking stress testing. Banks should analyze their liquidity position to assess their resilience to cope with stress situations. Some plausible stress scenarios relating to liquidity risk may include the following:
	i.	Deposits Withdrawals: Banks may develop scenarios of significant deposits withdrawals or major shifts in different categories of deposits e.g. from current deposits to term deposits, and analyze their impact on their liquidity and funding costs. The banks may assume different levels of withdrawals for current, savings and term deposits, and for local and foreign currency deposits;
	ii.	Tightening of Credit Lines: The banks which are heavily reliant on inter-bank borrowing should develop scenarios involving tightening or withdrawal of available inter-bank credit lines, identify alternate sources of funding and estimate the impact of such changes on the funding cost and profitability of the bank;
	iii.	Significant Maturity Mismatches: Such scenarios may be involved assumed widening of gaps in the overall and individual maturity buckets of total assets and liabilities as well as in the rate sensitive assets and liabilities, and assessing their implications for the liquidity management;
	iv.	Repayment Behavior of Borrowers: Banks may develop scenarios linking the level of projected cash flows with different assumed patterns of loan repayments. For instance, a stress scenario may assume delayed payment or prepayment of loans by some large borrowers and assess the impact thereof on liquidity position and earnings of the bank.
Banks may assess the resilience of their liquidity position by calculating the ratio of liquid assets to liquid liabilities” before and after the application of shocks. For this purpose, the liquid assets are the assets that can be easily and cheaply turned into cash and includes cash, balances with other banks and SAMA, inter-bank lending/placements, lending under repo and investment in government securities. The liquid liabilities includes the short-term deposits and borrowings. The ratio of liquid assets to liquid liabilities may be recalculated under each scenario to analyze the changes in liquidity position.