What is liquidity?

Liquidity is a financial term that means the amount of capital that is available for investment. Today, most of this capital is credit, not cash. That's because the large financial institutions that do most investments prefer using borrowed money. High liquidity means there is a lot of capital because interest rates are low, and so capital is easily available. Interest rates are so important in controlling liquidity. These rates really dictate how expensive it is to borrow. Low interest rates mean credit is cheap, so businesses and investors are more likely to borrow. The return on investment only has to be higher than the interest rate, so more investments look good. In this way, high liquidity spurs economic growth. However, a liquidity glut can develop if there is really too much capital looking for too few investments. This is usually a precursor to inflation. As cheap money chases fewer and fewer good ventures-- or houses, or gold, or barrels of oil, or high tech companies -- then the prices of those assets increase. This leads to "irrational exuberance." Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell. This is what happened with mortgage-backed securities during the 2007 Banking Liquidity Crisis. This phase of the business cycle, known as contraction, usually leads to a recession.

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Constrained liquidity means there isn't a lot of capital available, or that it's really expensive. Banks and other lenders are hesitant about making loans. It's usually a result of high interest rates.

What Does Liquidity Crisis Mean?

A negative financial situation characterized by a lack of cash flow. For a single business, a liquidity crisis occurs when the otherwise solvent business does not have the liquid assets (i.e., cash) necessary to meet its short-term obligations, such as repaying its loans, paying its bills and paying its employees. If the liquidity crisis is not solved, the company must declare bankruptcy. An insolvent business can also have a liquidity crisis, but in this case, restoring cash flow will not prevent the business's ultimate bankruptcy.

For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy, banks and the commercial paper market, severely reduce the number of loans they make or stop making loans altogether. Because so many companies rely on these loans to meet their short-term obligations, this lack of lending has a ripple effect throughout the economy, causing liquidity crises at a plethora of individual companies, which in turn affects individuals.

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Causes of recent liquidity crisis of banking sector

Liquidity refers to the supply of the means of payments of an economy. In Bangladesh, the totality of liquidity is indicated by what is called 'broad money' or M2. A shortage of money restricts demand by making it more difficult to engage in transactions. Investment is particularly susceptible to

liquidity. Now the main causes o f liquidity crisis of banking sector are given below:

In the recent year, our country has experienced a decline in the value of Tk against US currency which has created has huge liquidity crisis in the banking sector. For this reason our country has failed to collect maximum amount of US dollar required to open letter of credit (LC) for local businessmen to import essential commodities for the country. As a result the importer is facing a severe crisis in their business.

The banks need to reserve huge amount of money with the Bangladesh Bank as it is mandatory for them to maintain the CRR and SLR. BB has recently increased the rate of CRR and SLR as a result the problem of liquidity crisis has been aggravated recently. The central bank during last December raised the cash reserve requirement (CRR) by six percent for commercial bank.

As the increased percentage of CRR and SLR the commercial bank is facing liquidity problem and for this reason to get rid of the problem this banks are concentrated to generate more deposits. To generate

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more deposits they have to increase the deposit rate which has a adverse effect in the society.

Government credit from banking sector that would create extra burden to the countrys banking sector and it creates more liquidity crisis in that sector. the government has already borrowed Tk 110 billion from the countrys banking sector to met the existing budget deficit during last 10 months (July 2010 to April 2011), while last year it repaid Tk 87.92 billion loans. In the recent future the commercial banks will be unable to provide loan to the private sector.

If the bankers do not abide by the norms of the central bank and lend out money un judiciously, there arises the problem with liquidity.

The abnormal long-term finance and unsatisfactory recovery position of short-, medium- and long-term loans will adversely affect the liquidity situation.

The liquidity crisis of the banking sector has been accelerated by the increased amount of inflation; thus increasing the price of overall

commodities for the general people. To keep peace with this inflationary effect, the people withdraw their savings from the banks and use this fund for their transactionary expenditure. As a result the bank faces liquidity crisis.

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The reason of liquidity crisis, if any persisting in the financial sector may be the non-recovery of loans. The overall percentage of recovery of loan is very alarming. By now the state-owned banks have taken many steps to recover their old loans but could not show any improvement. The state-owned public limited companies should give due consideration to waiver of interest. But the businessmen or traders who failed to repay loans due to various reasons cannot afford to bear the burden of huge interest and suit costs.

In yearly period, the commercial banks perform activities of investment banks, and for investment banks to also perform activities of commercial banks (i.e. to borrow short and to lend long). As a result there is a combination problem of liquidity risk and credit risk and the problem becomes more uncontrollable and severe.

Overexposure in deposit-lending ratio, credit to deposit ratio (CDR) is causing the liquidity crisis of the private commercial banks (PCBs). Besides to make windfall profit and engaged in unhealthy competition amongst the banks leading the banking into a deep crisis. Although the Bangladesh Bank (BB) has set June 30 as deadline for bringing down to CDR to a rational level, still many of the private banks are lagging behind to maintain it, according to a BB official.

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Relationship of liquidity with the reserve and call money rate: Excess reserve with Bangladesh Bank has been decreased by BDT70 billion in first six months, indicating an active money market.

The excess reserve is hard cash deposited by banks in addition to cash reserve requirements, and it lies idle with the central bank and bears no return. Repo and reverse repo rate were both raised by 50 basis points to 6% and 4% respectively, causing liquidity to drop. Now we will see the graphical presentation of the relationship of the excess reserve and the liquidity of the banks.

Call money rate rose to double digit in December 2010 (Figure 2) mainly due to increased demand for fresh funds in the inter-bank money market. The demand for fresh funds was slightly higher on the day following the

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increment of cash reserve requirement (CRR) by the central bank to curb inflationary pressure on the economy. Under the new rules, the commercial banks will have to maintain a CRR of 6.00% instead of the previous 5.5% with the central bank from their total demand and time liabilities on a biweekly basis.

The proposed budget created a liquidity crisis in the banking sector due to its over-reliance on domestic borrowing for implementing the annual development program. If the government borrows hugely for implementing the ADP, the industrial sector will not get enough loans from the banking system, which will ultimately lead to a higher bank interest rate. In the budget for the next fiscal year, the government proposed bank borrowing of 7|Page

Tk 18,957 crore for meeting the deficit and spending in different sectors. Raising the tax at source to 1.5 percent from 0.40 percent will hamper the country's exports.

How banks manage liquidity risk

Liquidity risk management is a crucial area of risk control that is not covered by the original Basel II accord. Liquidity Risk is the risk of not being able to meet obligations when they come due because it cannot: Liquidate assets or obtain adequate funding , this is called "funding liquidity risk". Easily unwind or offset specific exposures without significantly lowering market prices because of inadequate market depth or market disruptions, which is called "market liquidity risk". The dual definition of the liquidity risk helps in understanding the nature of the risks; while funding liquidity risk focuses on company specific funding problems, market liquidity risk describes general market liquidity disruptions. The core of the liquidity risk strategy of a commercial bank must include following main components; Regular monitoring of net funding position and net funding gap of the bank;

The Treasury monitors all maturing cash flows, replenishes existing funds as they mature, monitors expected withdrawals from retail current and savings accounts and makes additional borrowings and regularly issues new debt.

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Diversification of funding sources;

The bank should posses well diversified funding sources including customer current accounts credit balances, savings and retail deposits and inter-bank deposits. Broad portfolio of highly liquid assets;

The bank has to maintain a broad portfolio of highly liquid or marketable assets that can be easily used to obtain cash. These assets can provide liquidity through repurchase agreements or through sale. Matching long term funding (over 12 months).

Fixed rate funding over 12 months and/or interest swaps (converting fixed rate liabilities over 12 months in floating rate liabilities). Set up quantitative limits and the limit structure. Set up clear crisis organization structure and escalation procedure. Tested and up-to-date contingency funding plans;

The contingency plans should address temporary and long-term liquidity disruptions caused by a crisis. These plans ensure that all roles and responsibilities are clearly defined.

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How this policy works in the crisis time:

Scenario 1: a short-time funding crisis related to a market event. The preferred order of generating liquidity in times of crisis is: 1. Determine per position the financial instruments available for generating liquidity during the crisis: An important element in this determination is the collateral position that must be held in times of crisis at the different central banks for supporting the payments system. The following trade off should be considered: a) Putting too much collateral at Central banks solves payment system issues but limits the secured funding possibilities with the money market. b) Putting collateral at work through repo (repurchase agreement) keeps financing secured but risks the payment system. 2. Unsecured professional funding. 3. Secured professional funding: a. Non-eligible assets in the professional repo market or through sale b. Eligible assets in the professional repo market or through sale 4. Central Bank funding (secured) through open market transactions (if available): a. Main Refinancing Operations (short term)

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b. Longer-term Refinancing Operations. c. Ad-hoc fine-tuning or structural operations of Central Banks 5. Funding through the Standing Facilities of the Central Bank (Lombard rate) 6. Funding through emergency funding possibilities with the Central Bank (non-eligible collateral) Scenario 2: In case of liquidity crisis is more severe and when it lasts for a longer banks begin to 1. Price deposits more aggressively. (Watch out for the banks that promote their deposit products with unbelievable high interest rates) 2. Reduce asset origination. 3. Raise term debt. 4. Raise equity.

Measures taken by commercial banks:

The Commercial banks have recently launched fund-collection campaigns by offering new saving schemes with higher interest rates in a bid to tackle the prevailing liquidity crisis. They are offering higher interest rates to lure people to keep their savings in the banks. Funds are needed to ward off liquidity crisis the banks are currently facing. A collapse of the countrys capital market has also pushed the banks to go for collecting more deposits.

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Prime Bank recently offered two fixed deposit schemes Lakhpoti deposit scheme and Prime millionaire scheme with interest rate ranging up to 13.50 per cent. The bank has also launched a double benefit scheme, which offers double the amount of saving after six years. The new deposit schemes introduced by Standard Bank are Standard Bank regular income programme, three yearly programme, double income plus programme, which offers to return double the amount of saving of five or 10 lakh taka after six years, Lakhpoti Plus of two- to 10-year terms, and Millionaire programme of three- to 13-year terms. Shahjalal Islami Bank has introduced double income scheme, which offers to return double the amount of saving after six years. The bank has also rescheduled its 12 existing deposit products by increasing the interest rates to a maximum of 14 per cent. BRAC Bank introduced SME fixed deposit scheme in April, which offers payment of interest after three and six months. Eastern Bank launched a new deposit scheme named SME Equity Builder in April, offering to provide monthly interest on the savings amount. NCC Bank has introduced double money scheme, offering a return double the savings amount after six years, special savings scheme of five- or 10-year term with higher interest, and Special Amanat scheme of 3-year tenure, which will provide Tk 1,000 as profit for Tk 1 lakh deposit.

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Jamuna Bank has launched a number of saving schemes with new interest rates and facilities. It is offering Kotipoti deposit scheme of 10- to 18-year tenures, double increase scheme, offering a return double the savings amount after five, eight, and 10 years, and triple increase scheme, offering a return triple the savings amount of Tk 10,000 or more after nine years. The bank will provide free debit cards to any one who will open a deposit account. The banks had always been trying to support their clients. The new deposit schemes will boost the banks confidence and the clients will be benefited. But the high deposit rate will create a pressure on the banks to increase their lending rates. The Bangladesh Banks move to increase the banks cash-reserve ratio compelled them to initiate more deposit programs with higher interests.

Contribution of bond market:

The bond market is a financial market where participants buy and sell debt securities, usually in the form of bonds. Like emerging-market countries around the world, Bangladesh could benefit from having a local-currency, fixed-income securities market. At present, its main fixed-income financial products are bank deposits, bank loans, government savings certificates, term loans, treasury bills, and government bonds and corporate debt (syndicated loans, private placement, and debentures). But in general the corporate debt market is still very small compared with the equity market. Numerous factors in Bangladesh today suggest that Bangladesh will not be able to develop an active, local-currency fixed-income market. Ideally, countries should try to build both primary and secondary markets for bonds. Primary markets reduce the three risks noted; secondary markets, by adding liquidity and broadening the investor base, help reduce funding costs. 13 | P a g e

Role of Bangladesh Bank:

At present CRR ratio is 6% and SLR is 18.5% for all scheduled commercial banks of Bangladesh. If Bangladesh Bank decreases the CRR and SLR then banks will get a huge amount of money which will help to solve the liquidity crisis many part.

At last we can say that positive role of Bangladesh Bank, calculative measure of all other banks and a strong bond market can solve the current liquidity crisis in Bangladesh.

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