LIQUIDITY GAP

Liquidity gaps are the differences at all future dates between assets
and liabilities of the banking portfolio.
Gaps generate liquidity risk, the risk of not being able to raise funds
without excess costs. Liquidity risk exists when there are deficits of
funds (whenever assets are greater than resources). Excess of funds
results in interest rate risk. Future deficits also create interest rate
risk
Controlling liquidity risk implies spreading over time amounts of
funding, avoiding unexpected important market funding and
maintaining a cushion of liquid short term assets so that selling them
provides liquidity without incurring capital gains and losses.
Asset Liability Management (ALM) structures the time schedule of
debt issues or investments in order to close the deficits or excess
liquidity gaps.
Liquidity Gaps are calculated as algebraic difference
between assets and liabilities. A positive gap is equal to
deficit and vice versa.

L
A
Gap

Time

Time Profile of Gaps

• Marginal or incremental gaps are the differences between
the changes in assets and liabilities during a given period.
A positive marginal gap means that the algebraic variation
of asset exceeds the algebraic variation of liabilities. The
marginal gaps represent the new funds required or the new
excess funds available for investing. When assets and
liabilities amortize over time, such variations are negative
and a positive gap is equivalent to an outflow. Fixed assets
and equity also affect liquidity gaps.
Static and Dynamic Gaps
Gaps based on existing assets and liabilities are static gaps.
These are time profiles of future gaps under cessation of
all new business, implying a progressive meltdown of the
balance sheet.
Gaps for both existing and new assets and liabilities are
required to project the total excesses or deficits of funds.
These are called dynamic gaps.
It is a common practice to focus first on existing assets and
liabilities to calculate the gap profile. One reason is that
there is no need to obtain funds in advance for new
transactions or to invest resources that are not yet
collected. Another reason is that dynamic gaps depend on
commercial uncertainties.
Liquidity Gaps and Risks
Liquidity gaps (deficits) create liquidity risk and interest rate risk.
Surpluses generate interest rate risk.
In a floating rate universe, interest rate risk will arise if there is
mismatch between the reference rates applicable to assets and liabilities
or the timing of resets of floating rate. If the asset return is indexed to 3
months LIBOR and the debt rate to 1 month LIBOR, the margin is
sensitive to changes in interest rate.
In some cases, interest rate risk may be present without the liquidity gap.
For example, a long fixed rate loan funded through a series of 3 month
loans carrying the 3 month LIBOR.
Future excesses or deficits in liquidity may be locked with respect to
interest rates now based on interest rate expectations and bank policy
with respect to interest rate risk.
Cash Matching
Cash matching is a basic concept for the management of liquidity and
interest rate risks. It implies that the time profiles of amortization of
assets and liabilities are identical. The nature of interest applicable (fixed
or floating) may also be the same.
With cash matching, liquidity gaps are zero. When the balance sheet
amortizes over time, it does not generate any deficit or excess of funds. If
in addition, interest rate resets are similar or if they are fixed interest rates
on both sides, the interest margin cannot change over time.
Cash matching is only a reference. In general, deposits do not match
loans. But it is possible to structure financial debt in order to replicate the
asset's time profile.
Cash matching can be done for individual transactions.. But cash
matching is implemented generally after netting assets and liabilities.
Liquidity Posture of the Balance Sheet

The liquidity posture of the bank is characterized by the

gap profile. The benchmark is zero liquidity gap. Various
typical situations are given below:

L L
A L A A

Gap profiles close to Deficits Excess Funds

zero

In all the above cases, the current gap is zero and non-
zero gaps appear only in the future. Once the debts
amortize completely, the level of capital is reached. The
figures ignore the gap between fixed assets and equity.
New Business Flows

With new business transactions, the gap profile becomes dynamic. The difference between the
total assets and existing assets at any date represent the new business

Total Assets

Total Liabilities
New Assets

New Liabilities
Existing Liabilities
Existing Assets
Cash Matching in a Fixed Rate Universe
It involves matching the profile of assets and target
resources. The process needs to define a horizon. The
treasurer then piles up 'layers' of debts starting from the
longest horizon. There can be two types of situations:
(i) The gap decreases continuously until the horizon.
(ii) The gap increases with time, peaks and then narrows.
Assets 1000 750 500
Resources 800 650 450
Gap 200 100 50
New Funding
Debt 1 50 50 50
2 50 50
3 100
Total Funding 200 100 50
Gap after funding 0 0 0
In the above case, the existing gap is 200 and the cash
matching funding necessitates debts of various maturities.
Layer 1 is a bullet debt extending from now to the end of
period 3. Its amount is equal to the gap at end of period 3
(50).
A second bullet debt from now to period 2 of amount 50
bridges the gap at period 2. There is still a gap of 100 left
for period 1. A bullet debt of 100 is contracted for one
period.
Assets 1000 750 500
Resources 800 400 400
Gap 200 350 100

New Funding

Debt 1 100 100 100

2 100 100
3 150
Total Funding 200 350 100
Gap after funding 0 0 0

In this case, the above process does not apply because the gap increases and after a while,
decreases until the horizon.

It is not possible to reach cash matching with resources raised today. One bullet debt of 100
bridges partially the gaps from now up to the final horizon. A second bullet debt of 100 starts
today and runs until the end of period 2. Then the treasurer needs a third forward starting debt
of 150. In a fixed rate universe, a forward contract should lock in its rate as of today.
However, effective raising of liquidity occurs only at the beginning of period 2 and remains
up to the end of period 2.
 ALM and Excess of Funds
When there are excess of funds, ALM should structure the timing of investments
and their maturities according to guidelines. This problem also arises for equity
funds because banks do not want to expose capital to credit risk by lending these
funds. It becomes necessary to structure a dedicated portfolio of investments
matching equity.
Investments are spread over successive periods of maturities to avoid locking in
the rate of a single maturity and the drawback of renewing entirely the
investment at selected maturity at uncertain rates. This policy smoothes the
changes of the yield curve shape over time up to the selected longest maturity.
There are variations around this policy such as concentrating the investment at
both short and long ends of the maturity structure of interest rates. Policies that
are more speculative imply views on interest rates and betting on expectations.
•
Problems in determining the liquidity gap time profile
The basic inputs to build the gap profile are the outstanding balances
of all assets and liabilities and their maturity schedules. However,
many assets have no explicit maturity e.g. overdrafts, credit card
consumer loans, renewed lines of credit, committed lines of credit
and other loans without specific dates. Demand deposits are
liabilities without maturity. Therefore assumptions, conventions or
projections are required to be used for these items. These are:
(i) Demand Deposits:
A large fraction of current deposits is stable over time
and represents the ‘core deposit base’
(ii) Contingencies such as Committed lines of credit :
The usage of these lines depends on the customer
initiative subject to the limit set by the lender.
(iii) Prepayment options embedded in loans: Even when the
maturity schedule is contractual, it is subject to
uncertainty due to prepayment options. The effective
maturity is uncertain
In case of demand deposits, there can be many solutions:
(i) Group all outstanding balances into one maturity bucket at
a future date , which can be the horizon of the bank. This
excludes the influence of demand deposit fluctuations
from the gap profile, which is neither realistic nor
acceptable.
(ii) Make a convention with respect to amortization e.g.
using a yearly amortization of 5 % to 10%. This
convention generates an additional liquidity gap equal to
this amortization forfeit every year which, in general is
not in line with reality.
(iii) Divide deposits into stable and unstable balances. The
volatile fraction istreated as a short term debt.
Separating core deposits from others is close to
reality though the rule for splitting the deposits into
core/ others could be crude.
(iv) Make projections modeled with some observable
variables correlated with outstanding balances of
deposits. Such variables include the trend of economic
conditions and some proxy for their short term
variations. Such analyses use multiple regression
techniques or time series analyses. However, this
approach also has limitations because all parameters
affecting deposits( like new fiscal regulations relating
to tax free earning of deposits which can alter the
allocation of customer resources between types of
deposits) cannot be considered. However, this
approach is closer to reality than any other.
• Contingencies given (Off –balance sheet): In such cases
like committed lines of credit, only the authorization and
its expiry date are certain and fixed. Statistics, experience,
knowledge of customers’ accounts and of their needs help
to make projections on the usage of such lines. Otherwise,
assumptions are required. However, most of these facilities
are variable rate and drawings are necessarily funded at
unknown rates. Matching both variable rates eliminates the
interest rate risk.
• Amortizing Loans : Prepayment of loans makes heir
effective maturity different from their contractual maturity.
Help of historical data and prepayment models can be
taken. Some models are simple that use a constant
prepayment ratio applicable to overall outstanding
balances. The more sophisticated ones make prepayment
dependant on several variables such as interest rate
differential between the loan and the market or the time
elapsed since origination.
Multiple Scenarios : Making use of assumptions and
conventions tends to hide the risks. Making these risks
explicit with several scenarios is a better solution.
For example, if deposit balances are quite uncertain, the
uncertainty can be captured by a set of scenarios such as base
case plus other cases where the deposit balances are higher or
lower. If prepayments are uncertain, multiple scenarios could
cover high, average and low prepayment rate assumptions.
The use of multiple scenarios makes the risk more explicit but
also introduce additional complexity. Besides, the scenarios
are judgemental making them less objective. The need is
therefore to have multiple sources of uncertainty such as
volume, prepayment and new business in a scenario.