The Monetary Policy Committee (MPC) meets every two months to review its monetary policy.

MPC is to meet from 8th to 10th Feb. In the last meeting in December, RBI had maintained the
status quo on rates. Read this thread to know about repo, reverse repo rate, CRR, SLR, etc

Updated Rates of Oct 2024

Repo Rate 6.50%
Reverse Repo Rate 3.35%
Cash Reserve Ratio
4.50%
CRR Rate
Bank Rate 6.75%
Statutory Liquidity Ratio
18%
(SLR) Rate

Repo rate: the rate at which a bank borrows from the RBI against the collateral of Government
securities. This borrowing is on an overnight basis. To illustrate, if a bank wants to borrow money
(say Rs.100) from RBI, it sells government securities to the RBI. The bank makes an agreement
with the RBI to repurchase these securities later at a predetermined rate (say Rs.105). The interest
rate charged on such borrowings (5%) is the Repo rate. If this rate increases, it becomes

activities decline. (Repo rate ↑ ⇒ money supply ↓). The current repo rate is 4%. It means that if a
expensive to borrow from the RBI. Therefore, banks increase their lending rates. Hence, lending

bank sells Government security to the RBI at Rs.100, it will buy back the security at Rs.104

Reverse Repo: Reverse repo is the rate at which banks keep their excess funds with the RBI
against the collateral of Government securities on an overnight basis. If the reverse-repo rate

decline (Reverse repo rate ↑ ⇒ money supply ↓). The current Reverse Repo rate is 3.35%.
increases, banks find it more profitable to keep their funds with RBI. Hence, lending activities

Cash Reserve Ratio (CRR): It is the % of deposits that a bank has to keep as reserves with the
RBI. When the Government increases CRR, the bank has to keep a larger percentage of its

the money supply also decreases. (CRR ↑ ⇒ money supply ↓). The current CRR is 4%.
deposits as reserves. It has lesser funds available to lend. Its capacity to lend decreases. Hence,

Importance of the CRR - Cash Reserve Ratio

o The main significance of the Cash Reserve Ratio (CRR) is to ensure that the banks do not
run out of money because of over-borrowing to their customers.

o If the CRR is set low by the Reserve Bank of India, the amount of liquidity of money or
the amount of cash available with the bank increases, which ultimately invests it in
various aspects like borrowing from the customers.

o This increases the risk of higher Non-Performing Assets (NPAs).

o However, a very high level of CRR can also negatively impact a nation's economy as it
lowers the amount of money available to commercial banks, which they can lend to their
customers.

o Thus, this ultimately reduces the amount of spending and investment in an economy.
 o CRR also plays the role of controlling the supply of money and the inflation level in an
economy.

o Suppose the level of inflation is high, which means that the liquidity of money is also
high. In that case, the Reserve Bank of India enhances the cash reserve ratio percentage,
ultimately reducing the amount of money the commercial banks can lend to their
customers.

o This finally reduces the liquidity of money in an economy and thus reduces inflation.

o In turn, when the level of inflation is low, which means that the liquidity of money in an
economy is also low, then the Reserve Bank of India reduces the cash reserve ratio
percentage, which enhances the amount of money available with the commercial banks
which they can use to lend more to their customers.

Statutory Liquidity Ratio: It is the % of deposits that a bank has to invest in risk-free assets
such as cash, gold, or Government securities. When the Government increases SLR, the bank has

amount to lend to consumers and businesses. Hence, the money supply decreases. (SLR ↑ ⇒
to keep a larger percentage of its deposits in cash, gold, and Government securities. It has a lesser

money supply ↓). The current SLR is 18 %.

Bank rate: Bank rate is the rate at which RBI lends funds to commercial banks. Unlike the repo
rate, there is no repurchasing agreement in the Bank rate. It is also the rate at which the RBI
purchases (rediscounts) bills of exchange or commercial papers from the banks. If this rate

rates. Hence, lending activities decline. (Bank rate ↑ ⇒ money supply ↓) The current bank rate is
increases, it becomes expensive to borrow from the RBI. Therefore, banks increase their lending

4.25%.

What are the types of accounts and deposits available?

It’s important to know where you can save your money. As the rule goes, high-risk on your
capital can result in a higher return while investing money in low-risk instruments would result in
lower interest.

Banks, including Bank of Baroda offer a host of instruments that are what can be termed as low
on risk and medium to low on return.

We shall now look at the various instruments that are available to a customer to deposit their
money with the bank and earn returns.

Types of Deposits

A primary function for a bank is to mobilise public money. They do so in the form of deposits.
There are two types of deposit accounts that you can open in a bank. They are time deposits and
demand deposits.

Time Deposits

A Time Deposit also known as a Term Deposit is a deposit which has a fixed tenure and earns
interest for the customer. The tenure varies for each instrument and may even change from bank
to bank.
The most widely used name for time deposits is Fixed Deposits. The common feature among all
Time deposits is that they cannot be withdrawn prematurely. One should thus plan their deposits
according to their requirement for money going forward.

The more the money resides in the bank of a term deposit the more interest it earns. Banks pay
higher interest in longer-term deposits than on shorter ones.

Fixed Deposits earn higher interest than a Savings Account because the former gives Banks leg
room to lend to people who need the money for roughly the same time limit. For example, a one
year fixed deposit in a bank can allow the bank to lend money to a person who requires a personal
loan for one year period.

Commercial banks have over the years made Fixed Deposits more attractive by offering various
frills like overdraft facility, zero cost credit cards, nomination facility, safe deposit lockers,
internet banking among others.

Recurring Deposits

In this case, a fixed amount, as decided by the depositor, is deposited at regular intervals till the
end of the tenure. The accumulated interest and the principal is given back to the depositor at the
end of the tenure. The tenure of a recurring deposit can be anything from six months to 120
months.

Demand Deposits

As the name suggested, you can withdraw this deposit on demand. Such funds are held in
accounts where it is easier to withdraw money either by going to the bank or an
ATM. Savings and Current accounts are the two types of commonly used Demand Deposits
account,

In such type of deposits, the risk is low but so is the return. However, there is one more factor that
this type of deposit has and that is liquidity since money can be withdrawn at a moment’s notice.

The reason for the existence of such accounts is to provide the customer convenience of meeting
his daily requirement of funds. It does not serve the purpose of ‘investment’ or ‘wealth creation’.

TYPES OF ACCOUNTS

Savings Account

These are interest-bearing accounts where the rate of interest depends on the bank where it is
deposited. Further, there are restrictions in terms of the number of times money can be withdrawn
from this account. These restrictions are also imposed by the bank and may vary between two
banks. The depositor can withdraw his money by going to the bank and use the withdrawal slip or
use his cheque book or go to an ATM and use his card. Money can also be transferred to someone
else by using the cheque facility or using an electronic mode of transfer.

Current Account

This type of account is generally operated by companies and firms. These are the non-interest-
bearing deposit and serve the purpose of providing liquidity. Since there are many transactions in
these accounts, the cost of managing them is high. Hence banks ask the depositors to maintain a
minimum deposit. Current accounts have overdraft facility which the banks provide the
customers to meet their short-term liquidity mismatch.

Types of Bonds

Bonds are a popular form of investment because they offer regular income, capital
preservation, and diversification benefits. It is a loan agreement between a borrower and a
lender. When an entity or an individual buys a bond, they lend money to the issuer for a
specific period.
The issuer promises to repay the amount at the end of the term with an agreed-upon interest
rate. This article discusses different types of bonds in India, their features, advantages,
limitations, and things to consider before investing.

What are the Types of Bonds?

Types of Bonds refer to different categories of bonds based on their issuer, maturity period,
and interest rate. One can classify bonds into various types depending on their characteristics
and market conditions. Some common types of bonds are treasury, fixed and floating rate,
corporate, high-yield, zero-coupon, and many more.
The risk and reward trade-off differs for each type of bond in finance. Understanding all
types of bonds is essential to select the best option.

List of Different Types of Bonds

1. Treasury Bonds
The central government issues treasury bonds. Hence, it is the safest type of bond because
there is no credit risk. These bonds have a maturity period of ten to thirty years and pay a
fixed interest rate, which is a factor in the prevailing market conditions.
2. Municipal Bonds
Local and state governments use these to gather funds for development projects such as
schools, highways, and hospitals. Municipal Bonds are exempted from tax. They are
available in both short-term and long-term maturities.
3. Corporate Bonds
Companies or business conglomerates issue corporate bonds to raise capital for their business
operations. They are riskier than treasury bonds because the creditworthiness of the issuing
company backs them. Corporate bonds can have varying maturities and interest rates,
depending on the issuer's creditworthiness and market conditions.
4. High-yield Bonds
Companies issue high-yield bonds with lower credit ratings and are riskier than investment-
grade bonds. They offer a higher yield to compensate for the higher risk. High-yield bonds
are also known as junk bonds.
5. Mortgage-Backed Securities
Real estate companies create mortgage-backed securities by pooling many mortgages and
issuing bonds against the underlying mortgage pool. The cash flow from the mortgages backs
these securities, so they are safer than corporate bonds because they carry less credit risk.
6. Floating Rate Bonds
Floating rate bonds have an interest rate adjusted periodically based on a reference rate, such
as the Reserve Bank of India's repo rate. It protects investors from interest rate risk because
the rates move with prevailing market rates. The interest rate of these bonds is subject to
market fluctuations and macroeconomic parameters.
7. Zero-Coupon Bonds
Zero-coupon bonds are issued at a discount to their face value and do not pay periodic
interest. Instead, they offer a fixed return at maturity, i.e., the difference between the issue
price and face value. They are ideal for investors who want to lock in a fixed return for a
specific period.
8. Callable Bonds
The issuer can redeem callable bonds before maturity, usually at a premium price. They offer
the issuer flexibility in managing their debt obligations but carry reinvestment risk for the
investor.
9. Convertible Bonds
The issuing company can convert these bonds into shares of the issuing company's stock at a
pre-determined conversion ratio. They offer the investor the potential for capital appreciation
and fixed income.
10. Inflation-Protected Bonds
The government issues inflation-protected bonds intending to protect investors from inflation.
They pay a fixed interest rate, which is adjusted periodically to reflect changes in the
Consumer Price Index.
Besides the above, borrowers structure the 5 types of bond products that suit their objectives
and are attractive to investors.
Features of Bonds
Bonds come with several features that distinguish them from other forms of investment.
A. Interest Rate: The interest rate is the coupon the bond issuer pays the bondholder.
Typically, it is a fixed percentage of the face value of the bond and is paid out periodically
over the bond’s life.
B. Maturity date: The maturity date refers to the redemption date, and the bond issuer
must repay the bond's principal amount to the bondholder. It is the date on which the bond
"matures."
C. Face value: The face value is the amount the bond issuer will pay the bondholder at
maturity. It is also known as the par value of the bond.
D. Yield: The yield is the rate of return on a bond. It is a percentage of the bond's current
market price. It considers both the coupon rate and the bond's current market price.
E. Credit rating: Credit rating agencies assign a bond rating based on the issuer's
creditworthiness. This rating reflects the likelihood that the issuer will default on its bond
payments.
F. Liquidity: Bonds can be bought and sold in the secondary market so that investors can
sell their bonds before maturity. The liquidity of a bond refers to the ease with which it can be
bought or sold in the secondary market.
Advantages of Bonds
There are various types of bonds to invest in, each with pros and cons. Bonds are a stable
investment option for risk-averse investors due to the dependability of interest and principal
returns. Some of these advantages include the following.
1. Steady income: Bonds typically provide a fixed income source through periodic interest
payments. This feature makes bonds an attractive option for investors seeking regular
income.
2. Diversification: Bonds offer an opportunity to diversify an investor's portfolio. They
tend to have a low correlation with other asset classes, such as equities and can help reduce
overall portfolio risk.
3. Lower risk: They are less risky than equities since they have a higher priority of
payment if the issuer defaults. Bondholders are also typically paid back before equity holders
are in liquidation.
4. Predictability: Bonds have a fixed term and interest rate, making them predictable
investments. This predictability can be especially attractive for investors seeking a stable,
low-risk investment.
5. Issuer flexibility: They can be issued in various forms and terms, allowing issuers
flexibility in raising capital. Bonds are customisable and meet the specific needs of the issuer,
such as funding long-term projects or managing short-term cash needs.
Limitations of Bonds
Despite their many advantages, bonds also have some limitations.
1. Interest rate risk: Generally, bond prices tend to fall when the interest rate increases. It
means that if an investor needs to sell their bond before maturity, they may have to sell at a
loss. This risk is particularly relevant in a rising interest rate environment.
2. Inflation risk: While bonds provide a steady income stream, inflation can erode the
value of that income over time. It means that investors may end up with less purchasing
power.
3. Credit risk: Bonds are only as good as the issuer’s creditworthiness. If the issuer
defaults, bondholders may not receive their entire principal and interest payments. One can
mitigate the risk by investing in bonds with higher credit ratings, but this generally comes at
the cost of lower yields.
4. Liquidity risk: Some bonds may be difficult to sell quickly, especially if they do not
trade frequently. It can be a problem for investors who must sell their bonds before maturity.
5. Limited potential for capital appreciation: While some bonds may experience capital
appreciation, the potential for price gains is generally limited. Investors looking for
significant capital appreciation may need to consider other investments.
Things to Consider Before Investing in Bonds
Before investing in bonds, there are several factors that investors should consider.
1. Credit Rating: The bond issuer's credit rating is a crucial factor to consider as it shows
the issuer's creditworthiness and repayment capacity. Higher credit ratings indicate lower
default risk but may also offer lower yields.
2. Interest Rates: Interest rates significantly impact bond prices. Bond prices tend to fall
when the interest rate rises, and vice versa. Investors should consider the current interest rate
environment when making investment decisions.
3. Maturity: Bonds with longer maturities generally offer higher yields but carry more risk
as they are more sensitive to interest rate changes. Conversely, short-term bonds offer lower
returns but are less susceptible to interest rate changes.
4. Yield: A bond's yield is the return an investor will receive on their investment. Higher
yields generally indicate higher risk. Investors should consider the yield with the credit rating
and other factors.
5. Liquidity: Some bonds are more liquid than others, meaning they can be easily bought
and sold. Less liquid bonds may be harder to sell and require a more extended holding period.
6. Tax implications: Investors should also consider the tax implications of investing in
bonds, as the interest income may be subject to taxes.
These factors assist investors in making informed decisions when investing in bonds.
How to invest in bonds in India?
Investors can buy through various channels, including banks, post offices, online trading
platforms, and mutual fund companies. Before investing, it is essential to research the five
types of bonds and their associated risks and returns.
Investors should also consider their investment goals, risk tolerance, and horizon. Bonds offer
a steady stream of income and diversification benefits to a portfolio.

Conclusion
In conclusion, bonds are a crucial part of the global financial system, providing a means for
governments, corporations, and other entities to raise capital. There are various types of
bonds, from government and municipal bonds to corporate and high-yield bonds. Each bond
type has its advantages and risks, and investors and issuers should carefully consider these
factors when deciding which bonds to invest in or issue.
Despite the risks, bonds remain a popular investment choice for those seeking steady income,
diversification, and lower risk, making them an important asset class in any well-diversified
portfolio.

Liquidity risk is the possibility an institution will be unable to obtain funds, such as customer
deposits or borrowed funds, at a reasonable price or within a necessary period to meet its
financial obligations.1
 This risk can impact both financial institutions and corporations, threatening their
operational and financial stability.
Liquidity risk is often characterized by two main aspects: market liquidity risk and funding
liquidity risk. Market liquidity risk happens when an enterprise cannot execute transactions at
current market prices due to insufficient market depth or disruptions. Funding liquidity risk is
the inability to obtain sufficient funding to meet financial obligations.
Various sectors, including banks, financial institutions, corporations, and even individual
investors, need to be concerned about liquidity risk. For banks and financial institutions,
managing this risk is vital and is often regulated by frameworks that enforce liquidity
standards to ensure financial stability and protect depositors. Corporations also need to
manage liquidity risk carefully, ensuring they have sufficient cash or access to credit to meet
their operational and financial obligations.
Key Takeaways
 Liquidity is a financial institution's ability to meet its cash and collateral obligations
without incurring significant losses. It ensures that it can handle expected and
unexpected cash flow demands without compromising its operations or financial
health.2
 Effective liquidity risk management involves ensuring the availability of sufficient
cash, liquid assets, and accessible borrowing lines to meet both expected and
unexpected liquidity needs.1
 Banks are guided by robust regulatory frameworks like Basel III, which sets stringent
liquidity standards to ensure financial stability and safeguard depositor interests,
highlighting the global focus on strong liquidity risk management.
 Unmanaged or poorly managed liquidity risk can lead to operational disruptions,
financial losses, and reputational damage. In extreme cases, it can drive an entity
toward insolvency or bankruptcy.
Understanding Liquidity Risk
Liquidity risk refers to the challenges a firm, organization, or other entity might encounter in
fulfilling its short-term financial obligations due to insufficient cash or the inability to convert
assets into cash without incurring significant losses. This risk may arise from various
scenarios, including market changes, unexpected expenses or withdrawals, or a sudden
increase in liabilities. The essence of liquidity risk lies in the mismatch between assets and
liabilities, where the assets can't be easily liquidated at market value to meet the short-term
obligations.
Liquidity risk management is critical to ensuring that cash needs are continuously met.
Common ways to manage liquidity risk include maintaining a portfolio of high-quality liquid
assets, employing rigorous cash flow forecasting, and diversifying funding sources.
Additionally, compliance with regulatory frameworks that establish minimum liquidity
standards serves as a proactive approach to managing liquidity risk.
The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-
reaching. It can lead to financial losses from selling assets at depressed prices, operational
disruptions due to inadequate cash flow, and reputational damage that can further exacerbate
liquidity issues. In extreme cases, liquidity risk can lead to insolvency or bankruptcy,
underscoring the imperative for robust liquidity risk management practices.
Liquidity risk often comes in two forms: market liquidity risk and funding liquidity risk. Both
dimensions of liquidity risk are interconnected and can exacerbate each other. For example,
an inability to secure short-term funding (funding liquidity risk) may force an entity to sell
assets at a loss (market liquidity risk), further weakening its financial position and deterring
potential lenders or investors.
Market Liquidity Risk
Market liquidity is defined by the ease with which an asset can be exchanged for
money.3 The risks relate to when an entity cannot execute transactions at prevailing market
prices due to inadequate market depth, a lack of available buyers for assets held, or other
market disruptions.
This risk is especially pronounced in illiquid markets, where imbalances in demand and
supply dynamics can make executing large transactions at a fair price challenging without
affecting the market. For example, selling a large volume of shares in a thinly traded stock
could significantly lower the share price, leading to a loss for the seller.
Funding Liquidity Risk
Funding liquidity risk pertains to the challenges an entity may face in obtaining the necessary
funds to meet its short-term financial obligations. This is often a reflection of the entity's
mismanagement of cash, its creditworthiness, or prevailing market conditions which could
deter lenders or investors from stepping in to help. For example, even creditworthy entities
might find securing short-term funding at favorable terms challenging during periods of
financial turbulence.
Liquidity and solvency are related terms, but differ in important ways. Liquidity risk relates
to short-term cash flow issues, while solvency risk means the company is insolvent on its
overall balance sheet, especially related to long-term debts. Liquidity problems can
potentially lead to insolvency if not addressed.
Liquidity Risk and Banks
Banks' liquidity risk naturally arises from certain aspects of their day-to-day operations. For
example, banks may fund long-term loans (like mortgages) with short-term liabilities (like
deposits). This maturity mismatch creates liquidity risk if depositors withdraw funds
suddenly. The mismatch between banks' short-term funding and long-term illiquid assets
creates inherent liquidity risk. This is exacerbated by a reliance on flighty wholesale
funding and the potential for sudden unexpected demands for liquidity by depositors.
Banks' meticulous management of liquidity risk is not only a prudential measure but a
regulatory imperative, mandated by robust frameworks like Basel III. Developed by the Basel
Committee on Banking Supervision, Basel III sets forth stringent liquidity standards aimed at
enhancing the banking sector's ability to absorb shocks arising from financial and economic
stress.4 Basel III standards apply to internationally active banks, and the rules apply broadly
to large EU, UK, Japanese, Canadian, and Australian banks with international
operations. However, exact requirements are set by national regulators. In the U.S., for
example, Basel III rules apply to bank holding companies with over $250 billion in assets,
and some requirements trickle down to smaller regional banks.5
Key components of Basel III include the liquidity coverage ratio(LCR) and the net stable
funding ratio (NSFR). The LCR mandates banks to hold high-quality liquid assets that can be
readily converted to cash to meet their net cash outflows over a 30-day stress-test scenario,
while the NSFR requires banks to maintain a stable funding profile concerning the
composition of their assets and off-balance sheet activities, promoting long-term resilience
against liquidity risk.
In addition to Basel III, several other regulatory frameworks and guidelines are in play for
banks, underlining the global emphasis on robust liquidity risk management. In the European
Union, the Capital Requirements Directive IV (CRD IV) and Capital
Requirements Regulation (CRR) govern liquidity risk management for banks.67 These
regulations incorporate the Basel III standards while providing a localized framework that
addresses the unique characteristics of the European banking sector. Similarly, in the United
States, the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act have
provisions that bolster liquidity risk management to protect depositors, including stress
testing requirements under the Comprehensive Capital Analysis and Review (CCAR) and the
Dodd-Frank Act Stress Test (DFAST) frameworks.8
How Banks Manage Liquidity Risk
Here’s a deeper dive into how banks navigate the waters of liquidity risk:9
1. Maintaining a balanced portfolio of liquid assets: Banks strive to maintain a
balanced portfolio of liquid assets that can be swiftly converted into cash without
significant loss in value. These assets, often termed as high-quality liquid assets
(HQLA), provide a safety buffer in liquidity crunches.
2. Utilizing liquidity ratios: Banks employ liquidity ratios like the liquidity coverage
ratio (LCR) and net stable funding ratio (NSFR) to monitor and manage their liquidity
risk. The LCR ensures that banks have enough high-quality liquid assets to withstand
a 30-day stress scenario, while the NSFR aims to promote longer-term resilience by
requiring a stable funding structure relative to the liquidity profile of the assets.
3. Stress testing: Conducting stress tests to simulate adverse market conditions is a key
strategy for identifying potential liquidity shortfalls. These tests help understand the
impact of various stress scenarios on a bank’s liquidity position, enabling it to take
preemptive measures.
4. Diversifying funding sources: Diversifying funding sources is a prudent strategy to
mitigate dependency on a single or few funding sources. This can include a mix of
 retail deposits, wholesale funding, and other financing avenues. A diversified funding
structure can provide a more stable and resilient liquidity profile.
5. Effective cash flow management: Banks need a robust cash flow
management system to track and manage their cash flows efficiently. This involves
monitoring the inflows and outflows, optimizing the asset-liability maturity profile,
and ensuring that there is adequate liquidity to meet both expected and unexpected
cash flow needs.
6. Establishing contingency funding plans (CFP): Banks develop contingency funding
plans to address potential liquidity shortfalls. These plans outline the strategies and
actions to be taken during a liquidity crisis, ensuring a structured and coordinated
approach to managing liquidity under adverse conditions.
7. Engaging in asset/liability management (ALM): Asset/liability management is a
comprehensive approach to balancing the bank’s assets and liabilities in a way that
minimizes liquidity risk. It involves coordinating lending, investment, funding, and
pricing strategies to ensure the bank can meet its obligations as they come due without
incurring unacceptable losses.

Types of risks in banks

1. Credit Risk

Credit risk, one of the biggest financial risks in banking, occurs when borrowers or
counterparties fail to meet their obligations. When calculating the involved credit risk,
lenders need to foresee and predict the possibility of them making back the loan, principal,
interest, and all.
2. Market Risk

Market risk is the risk of losing value on financial instruments on the back of adverse price
moments driven by changes in equities, interest rates, credit spreads, commodities, and FX.
3. Liquidity Risk

Liquidity refers to a bank’s ability to meet its collateral and cash obligations while avoiding
major losses. Liquidity risk is the risk of incurring losses where certain commodity or
investment cannot be traded without impacting its market price.

4. Model Risk

Model use at large banks is growing by more than 20% each year (IDC), which in turn leads
to greater model risk. Banks must manage model accuracy to prevent significant financial
losses when assumptions grow, models are misused, or other forms of malfunction
occur. Read our blog, to learn the four tips that our model risk management experts share on
how to increase your model risk management efficiency by 50%.

5. Environmental, Social and Governance (ESG) Risk

Environmental, social, and governance events, from climate change to diversity and inclusion
policies, can have material impact on the value of investments. Banks must proactively
measure and manage these risks, integrating ESG data, scoring models, and climate models
into the investment process and credit risk evaluations.

Types of non-financial risk:

6. Operational Risk
Operational risk is the risk of losses incurred by inadequate internal processes, people, and
systems, or from external events.
7. Financial Crime

Money laundering, corruption, fraud are examples of financial crime, leading to economic
benefits for individuals through illegal ways. Banks need to make sure they develop fool
proof techniques to avoid the losses posed by financial crime.

Find out how Evalueserve helped a top US bank combat financial crime and improve their
monitoring and reporting models.
8. Supplier Risk

Banks often have large, global supply chains. In the event that suppliers disrupt business
continuity or put customer data at risk, banks are increasingly held responsible by regulators.
9. Conduct Risk

Conduct risk occurs when banks incur financial loss due to inaccurate management choices
or decisions by the employees and team members.
With the many risks banks and financial organizations face, time is of the essence especially
as global economies and markets try to recover from the uncertainty brought on by the
pandemic.
In the event of a financial crisis, a run on the banks could prove disastrous
for the global economy. That hasn’t gone unnoticed by the global financial
industry, and it’s the reason why the LCR (liquidity coverage ratio) was
invented. But what is the liquidity coverage ratio, and how could it help
protect banks and financial institutions from financial collapse? Get the
inside track on the LCR ratio with our liquidity coverage ratio summary.

Liquidity coverage ratio summary

Developed by the Basel Committee on Banking Supervision (BCBS) – a

group of representatives from global financial centres – the LCR ratio is
the main takeaway from the Basel Accord. It was first proposed in 2010
before it was given final approval in 2014, although the 100% minimum
wasn’t required until 2019. But what does the LCR (liquidity coverage
ratio) mean?

Put simply, the liquidity coverage ratio is a term that refers to the
proportion of highly liquid assets held by financial institutions to ensure
that they maintain an ongoing ability to meet their short-term obligations
(i.e., cash outflows for 30 days). 30 days was selected because, in a
financial crisis, a response from governments and central banks would
typically take around 30 days.

In other words, the liquidity coverage ratio is a stress test that is intended
to make sure that banks and financial institutions have a sufficient level of
capital to ride out any short-term disruptions to liquidity. It applies to
banks with over $250 billion in total consolidated assets or banks with
over $10 billion in on-balance sheet foreign exposure.

Understanding the LCR ratio formula

There is a simple LCR ratio formula that you can use to calculate LCR:

LCR = High-Quality Liquid Asset Amount (HQLA) / Total Net Cash Flow
Amount
So, to calculate the LCR (liquidity coverage ratio), you’ll need to divide the
bank’s high-quality liquid assets by their total net cash flows over the
course of a specific, 30-day stress period.

What is a HQLA?

HQLAs are assets with the potential to be converted into cash quickly and
easily. Under the Basel Accord, there are three categories of liquid assets –
level 1, level 2A, and level 2B:

 Level 1 – These assets include coins and banknotes, central bank

reserves, and marketable securities. Level 1 assets aren’t
discounted when you calculate the LCR ratio.

 Level 2A – These assets include securities issued/guaranteed by

specific sovereign entities or multilateral development banks, as
well as securities issued by US government-sponsored enterprises.
Level 2A assets have a 15% discount.

 Level 2B – These assets include investment-grade corporate debt

and publicly-traded common stock. Level 2B assets have a 25-50%
discount.

Banks and financial institutions should attempt to achieve a liquidity

coverage ratio of 3% or more. In most cases, banks will maintain a higher
level of capital to give themselves more of a financial cushion.

Limitations of the liquidity coverage ratio

The LCR ratio formula is immensely important because it ensures that

banks and financial institutions have a substantial financial cushion in a
crisis. However, there are a couple of significant limitations associated
with LCR (liquidity coverage ratio). Firstly, it requires banks to hold onto
more cash. Consequently, fewer loans could be issued to businesses or
consumers. It’s also crucial to remember that it’s impossible to know
whether the LCR ratio provides a strong enough financial cushion for
banks until the next financial crisis happens, at which point, the damage
will already be done.

To resist economic crises and ensure stability to banks, two financial

regulation tools have been designed to reduce the risk of liquidity shock:
the liquidity coverage ratio (LCR) and the net stable funding ratio
(NSFR). However, these two measures pursue different objectives and are
based on different evaluation criteria.
Two capital requirements

During the 2007-2009 financial crisis, several banks – including the British
institution Northern Rock and the US investment banks Bear Stearns and
Lehman Brothers – suffered a liquidity crisis, due to their overdependence
on short-term wholesale funding stemming from the inter-bank loans
market. Consequently, the G20 launched a review of the banking
regulation package known as Basel III. In addition to changes to capital
requirements, the Basel III framework also introduced two liquidity
requirements:

 the liquidity coverage ratio (LCR);

 the net stable funding ratio (NSFR).

In the early phases of the above-mentioned crisis started in 2007, despite

adequate capital levels, many banks faced problems caused by their
inability to prudently manage liquidity. In fact, that crisis evidenced the
importance of this aspect for the proper functioning of financial markets
and the banking system.

What is LCR

In the event of a financial crisis, a bank-counter race of the investors to

withdraw their money may prove to be disastrous for global economy. This
risk has not gone unnoticed in the credit and financial sector and it is the
reason why LCR has been developed in the first place. So, what does
this liquidity coverage ratio consist of and how could it help
protecting banks and financial institutions from a potential
financial collapse?

The LCR, developed by the Basel Committee on Banking

Supervision (BCBS), is the main principle of the Basel
Arrangement. The LCR was first proposed in 2010 and definitely
approved in 2014, even though banks were not required the 100% until
2019 (there has been a phased-in implementation, starting from the 60%
requirement in 2015 and gradually increasing over time). But what does
the acronym LCR (literally, liquidity coverage ratio) mean?

In a nutshell, the liquidity coverage ratio expresses a bank’s ability to

cover its short-term needs with highly liquid assets held, such as:

 money;

 government bonds;

 corporate bonds.

What is the purpose of LCR

This measure prevents banks from suffering liquidity difficulties when
covering short-term bonds. Banks are thus required to hold LCR in
quantities at least equal to total bonds over the next 30 days. The 30-days
deadline has been chosen because, during a financial crisis, central banks
and governments’ response would normally require a time span of about
30 days.

In other words, the liquidity coverage ratio is a cash stress, which

aims at guaranteeing that banks and financial institutions hold
sufficient capital to overcome any short-term liquidity
discontinuities.

The formula to calculate the LCR

The following formula can be used to compute the LCR:

LCR = high quality liquid assets (HQLA) amount / total amount of

net cash flow

Therefore, to determine the LCR banks need to divide their high-quality

liquid assets by the total net cash flows over a specific stress test period
of 30 days.

Basically, the LCR relates to short-term liquidity risk management,

assessing banks’ ability to cover their liquidity needs over a 30-days
period under a cash stress scenario.

LCR limits

The difficulties faced by some banks are due to a failure to comply with
the basic principles of liquidity risk management. The LCR formula is thus
extremely important because it guarantees banks and financial
institutions a substantial financial buffer during crisis events.

Nonetheless, the LCR features two significant limits. In the first

place, it requires banks to hold more liquidity. As such, they may
grant fewer loans to undertakings or consumers. Moreover, it is key to
remember that knowing whether the LCR provides banks with a
sufficiently sound financial buffer is quite impossible until the next crisis
occurs but, at that point, the damage would already be done.

What is HQLA

There is another crucial acronym related to LCR calculation: HQLA.

The Bank for International Settlements (BIS) defines high-quality
liquid assets as the following: ‘Assets may be considered HQLAs if they
can be easily and immediately converted into money with little or no loss
in value. The liquidity of an asset depends on the underlying stress
scenario, the volume to be monetized and the considered time horizon.
However, some assets are most likely to produce funds without incurring
high discounts in selling or repurchase agreements markets, due to forced
sales even in times of stress.’

HQLAs and Level 1, Level 2A and Level 2B assets

Therefore, HQLAs are assets which can be quickly and easily

converted into cash. According to the Basel Agreement, there are three
categories of liquid assets: Level 1, Level 2A and Level 2B.

 Level 1 – these assets include coins and banknotes, central bank

exposures and assets representing claims on or guaranteed by
some central or regional governments, local authorities or public
sector entities. Mostly, Level 1 assets are not discounted when
determining the LCR;

 Level 2A – these assets include securities issued or guaranteed by

specific sovereign entities or multilateral development banks, as
well as securities issued by specific third-country sovereign entities.
Mostly, Level 2A assets have a 15% discount.

 Level 2B – these assets include investment grade corporate debt

and common shares listed on the stock exchange. Mostly, Level 2B
assets have a 25-50% discount.

Banks and financial institutions need to keep a liquidity coverage ratio

equal to or greater than 100%. In most cases, banks would hold higher
capital levels to secure a larger financial margin.

What is NSFR

The LCR index is complemented by another indicator, the Net Stable

Funding Ratio. The NSFR has a long-term view on banks’ liquidity risk
management, assessing their ability to finance assets and commitments
within a year under a cash stress scenario.

The NSFR is the ratio between:

 available amount of stable funding;

 required amount of stable funding.

Also in this case, the minimum requirement is 100%.

What is a stable funding

A stable funding includes risk and debt capitals which are deemed to
constitute reliable funds over a 12-month time horizon and under
prolonged stress conditions.
This stable funding takes account of:

 capital;

 privileged equities with a maturity of one year or more;

 liabilities with a maturity of one year or more;

 demand deposits for short-term funding;

 long-term wholesale funding share.

In other words, the net stable funding ratio seeks to calculate the share
of available stable funding (ASF) through equities and certain
liabilities, with respect to the required stable funding (RSF) (through
assets).

NSFR implementation

The net stable funding ratio was also introduced as part of Basel
III regulations and entered into force in 2018. The 100% requirement has
been binding only since 30th June 2021.

What Is Stress Testing?

In business, stress testing is a technique used to test the resilience of

institutions and investment portfolios against possible future financial
situations. The financial industry customarily uses such testing to help
gauge investment risk and the adequacy of assets and evaluate internal
processes and controls. In recent years, regulators have also required
financial institutions to carry out stress tests to ensure their capital
holdings and other assets are adequate.

Key Takeaways

 Stress testing is a computer-simulated technique to analyze how

banks and investment portfolios fare in drastic economic scenarios.

 Stress testing helps gauge investment risk and the adequacy of

assets, as well as to help evaluate internal processes and controls.

 Stress tests can use historical, hypothetical, or simulated scenarios.

 Regulations require banks to carry out various stress-test scenarios

and report on their internal procedures for managing capital and
risk.

 The Federal Reserve requires banks with $100 billion in assets or

more to perform a stress test.